layout: true background-image: url(figs/tcb-logo.png) background-position: bottom right background-attachment: fixed; background-origin: content-box; background-size: 10% --- class: title-slide .row[ .col-7[ .title[ # Principles of Macroeconomics ] .subtitle[Fiscal Policy] .author[ ### Dennis A.V. Dittrich ] .affiliation[ ] ] .col-5[ ] ] --- class: practice-slide # 1. What is fiscal policy? ??? Expansionary: increase in government spending, tax cut, increase in transfer payments. Contractionary: reduction in government spending, tax increase, decrease in transfer payments. Specific examples could include changes in military spending, domestic spending, Social Security payments, personal or corporate taxes, etc. --- # The Modern Fiscal Policy Dilemma .col-7[ **Fiscal Policy**: federal government policy on taxes, spending, and borrowing that is designed to influence business fluctuations. Two categories of fiscal policy during a recession -- One goal * The government spends more money. * The government cuts taxes. In either case, the goal: greater spending. The **modern fiscal policy dilemma** is that when faced with the economy falling into a depression: * Governments need to run large deficits (for limited periods) A government that cannot easily sell its debt will either go bankrupt or have to resort to inflationary finance, with the central bank financing the government by printing money ] --- # Classical Economics and Sound Finance .col-7[ **Sound finance** was a view of fiscal policy that the government budget should always be balanced except in wartime * This view was based on a combination of political and economic grounds, but primarily on political grounds Given the collapse of economic expectations in the 1930s, many economists of the time favored giving up the principle of sound finance, at least temporarily, and using government spending to stimulate the economy * If the economy is in a small recession, do nothing * If the economy is in a depression, use deficit spending ] --- ## Keynesian Economics and Functional Finance .col-7[ **Functional finance** held that governments should make spending and taxing decisions on the basis of their effect on the economy, not on the basis of some moralistic principle that budgets should be balanced * If spending was too low, government should run a deficit; if spending was too high, government should run a surplus * Functional finance nicely fits the AS/AD model Watch: _Fear the Boom and Bust_ a Hayek vs. Keynes Rap Anthem http://youtu.be/d0nERTFo-Sk _Fight of the Century_: Keynes vs. Hayek Round Two http://youtu.be/GTQnarzmTOc ] --- # Fiscal Policy: The Best Case .row[.col-6[ ![](img12/f3701.jpg) ] .col-6[ Effect of a decrease in consumer spending growth: This is equivalent to a decrease in velocity What happens? * AD shifts to the left * Because wages are sticky, the decline in velocity is split between lower real growth and lower inflation. * The economy moves from a to b. * The economy goes into a recession. Can fiscal policy help? ]] --- # Fiscal Policy: The Best Case .row[.col-6[ ![](img12/f3701.jpg) ] .col-6[ Effect of a decrease in consumer spending growth: * In the long-run wages will adjust and will return to its normal growth rate. * The economy will move from b to a. * The recession will be over. [...] the long-run may take too long. The point of fiscal policy is to end the recession sooner. ]] --- # Fiscal Policy: The Best Case .row[.col-6[ ![](img12/f3702.jpg) ] .col-6[ **The Multiplier Effect**: the additional increase in AD caused when expansionary fiscal policy increases income and thus consumer spending. * When government spends money, incomes of certain people rise. * As these people spend their money, incomes of additional people rise and so on. * The greater the multiplier, the greater will be the effect of the increase in government spending on the velocity. ]] --- class: practice-slide # 2. .row[.col-9[ Nobel Laureate Amartya Sen has pointed out that one way to prevent starvation during droughts in the poorest countries is to just pay peasants to build roads, sewer lines, and other public goods during these droughts. In the poorest countries, these peasants have no savings accounts, and almost no way to borrow money. In rich countries by contrast, most people have savings accounts and credit cards. ]] .row[.col-6[ a. Is the poor-country "multiplier" probably bigger or smaller than the rich-country multiplier, based on these facts? ] .col-6[ b. All countries get hit by shocks, but not all countries have the same automatic stabilizers. Based on these facts, which countries probably have smoother GDP growth: poor countries or rich countries? ]] ??? a. Poor countries probably have bigger multipliers. For developing countries, the figure was even worse. A $1 injection would result in a decline in GDP by 63 cents. Why? Some economists put it down to the high volatility of government consumption in developing countries. Developing countries often see one year of government expansion, followed by another of government contraction. And this makes it difficult for a multiplier effect to get going. In poor countries, every bad shock to the economy makes it much harder for poor people to buy consumer goods, while every good shock makes it easier for poor people to buy consumer goods. b. Poor countries have more volatile GDP growth: Their ups and downs are much larger. A large literature growing out of the Ramey and Ramey paper has confirmed this result. ??? class: practice-slide # 3. What are the critical assumptions of (the multiplier model in) public finance in practice? --- # Public Finance in Practice .col-7[ Six assumptions (of the multiplier model) that could lead to problems with fiscal policy are: 1. Financing the deficit doesn't have any offsetting effects 2. Government knows what the situation is 3. Government knows the economy's potential income level 4. Government has flexibility in changing spending and taxes 5. The size of the government debt doesn't matter 6. Fiscal policy doesn't negatively affect other goals ...and some further limits: * The economy may so large that government can rarely increase spending enough to have a large impact. * Shifting AD doesn't help much to combat real shocks. ] --- ### Financing the deficit does(n't) have any offsetting effects .row[ .col-7[ **Crowding out** is the offsetting of a change in government expenditures by a change in private expenditures in the opposite direction ![](img12/3501b.jpg) ] .col-5[ Crowding out as a Result of Raising Taxes to Finance Fiscal Policy * Higher taxes reduce private spending. * The greater the fraction of additional income that is spent, the greater will be crowding out. * Fiscal policy will be most effective when people are otherwise afraid to spend their money. ]] --- class: practice-slide # 4. .row[ .col-6[ If interest rates have no effect on investment, how much crowding out will occur? ] .col-6[ ![](img12/f2906.jpg) ] ] ??? No crowding out --- ### Financing the deficit does(n't) have any offsetting effects .row[ .col-7[ Government borrowing can squeeze out private borrowing especially if the pool (of funds) is limited... Selling More Bonds to Finance Fiscal Policy * The supply of bonds increases. * Bond prices fall and interest rates rise * Higher interest rates lead to less private spending. * Bond-financed fiscal policy will be most effective when the private sector is reluctant to save or invest. * Private spending will be less sensitive to changes in interest rates. ] .col-5[ Crowding out through Selling More Bonds to Finance Fiscal Policy ![](img12/f3703.jpg) ]] --- class: practice-slide # 5. .col-8[ Consider the following imaginary newspaper quote, the type that you often read when Congress passes a tax rebate during a recession: _"Many Americans report that they will put the tax rebate straight into their savings accounts or use it to pay off credit cards that they maxed out during the recent economic boom."_ If Congress is trying to shift AD to the right, are these kinds of quotes good news or bad news from Congress’s point of view? ] --- # Crowding out: Ricardian Equivalence .col-7[ **Ricardian Equivalence** occurs when people see that lower taxes today mean higher taxes later. They save their tax cut to pay future taxes. * Ricardian equivalence describes some people but not all. How many of us systematically save tax cuts to prepare for future government austerity? * To the extent that this occurs, bond-financed tax cuts are less effective in the short-run. ] --- class: practice-slide ## 6. .row[.col-9[ Imagine you live in the land of Ricardia, where every citizen is a Ricardian and thus “Ricardian equivalence” is 100% true. Government spending never changes in Ricardia: It’s a fixed amount every year. Thus, when the Ricardian government cuts taxes, it has to pay for the government spending by borrowing more money and raising future taxes to repay the debt. ]] .row[.col-6[ a. When Ricardian income taxes are cut, what will Ricardian citizens do with the extra money in their paycheck: Will they spend all of it, save all of it, or spend some and save the rest? ] .col-6[ b. Suppose that instead of a tax cut, the Ricardian government just sends citizens “rebate” checks. What will Ricardian citizens do with the extra money from these rebate checks: Will they spend all of it, save all of it, or spend some and save the rest? ]] ??? In both cases, Ricardian citizens will save all of a tax cut or rebate check to pay for higher future taxes. --- # 7. .row[ .col-7[ **Crowding out**: A decrease in private consumption or investment in response to an increase in government purchases. The idea works in reverse as well. A shock! A large decrease in government purchases, perhaps caused by the end of a war. * Consider a possible side effect of the fall in the growth of G: the reversal of crowding out or crowding in. If there is 100% _crowding in_, what happens to the AD shift just described? * If there were 100% crowding out/in and no multiplier effect, what can we say about the effect of a change in the growth of G on aggregate demand? ] .col-5[ ![](img12/f3706.jpg) ]] --- # Crowding IN .row[ .col-7[ * With 100% crowding in, the decrease in G is matched by an increase in private consumption and investment spending, which returns us to the original AD curve. * If there is 100% crowding out/in and no multiplier, then any change in the growth of G has absolutely no impact on aggregate demand. Consider all of the laid-off government workers in this question: If there were 100% crowding out/in and no multiplier effect, where do these laid-off workers end up? ] .col-5[ ![](img12/f3706.jpg) ]] --- class: practice-slide # 8. .col-8[ Why does a reduction in taxes have a smaller multiplier effect than an increase in government spending of an equal amount? ] ??? The tax multiplier is smaller than the spending multiplier. This is because the entire government spending increase goes towards increasing aggregate demand, but only a portion of the increased disposable income (resulting for lower taxes) is consumed. The multiplier effect of a tax cut can be affected by the size of the tax cut, the marginal propensity to consume, as well as the crowding out effect. --- .col-8[ ![](img12/f3704.jpg) ] --- ## (Not) Knowing .row[ .col-6[ ### ...What the Situation Is Data problems limit fiscal policy for fine tuning * Getting reliable numbers on the economy takes time * We may be in a recession and not know it The government has large econometric models and leading indicators to predict where the economy will be in the future, but the forecasts are imprecise ] .col-6[ ### ...the Level of Potential Income No one knows for sure the potential full-employment income * Almost all economists believe that potential income is within an unemployment rate range of 3.5% to 10% * Differences in estimates of potential income often lead to different policy recommendations In most cases, the economy is in an ambiguous state where some economists are calling for expansionary policy and others are calling for contractionary policy ]] --- class: practice-slide # 9. .col-8[ Which kind of aggregate demand shift has fewer lags: changes in monetary policy or changes in fiscal policy? ] --- ## (No) Flexibility in Changing Taxes and Spending .row[.col-7[ Fiscal policy is intended to correct short-term problems. By the time fiscal policy is in place, economic conditions have often changed. Putting fiscal policy into place takes time and has serious implementation problems * Recognition -- Problem must be recognized. * Legislative -- Parliament must propose and pass a plan. * Implementation -- Bureaucracies must implement the plan. * Effectiveness -- The plan takes time to work. * Evaluation and Adjustment -- Did the plan work? Have conditions changed? ] .col-5[ Numerous political and institutional realities make implementing fiscal policy difficult * Disagreements between the legislative and the executive branch of government may delay implementing appropriate fiscal policy for months, even years ]] --- class: practice-slide # 10. .col-8[ What are automatic stabilizers? How do they work? ] ??? An automatic stabilizer is a tax or spending institution that tends to increase government revenues or lower government spending during economic expansions, but lower revenues or raise government spending during economic recessions. Example include unemployment compensation, which rises during recessions, and personal income tax receipts, which rise during expansions. --- # Building Fiscal Policy into Institutions .row[ .col-6[ To avoid the problems of direct fiscal policy, economists have attempted to build fiscal policy into their countries' institutions An **automatic stabilizer** is any government program or policy that will counteract the business cycle without any new government action Automatic stabilizers include: * Welfare payments * Unemployment insurance * The income tax system ] .col-6[ When the economy is in a recession, the unemployment rate rises * Unemployment insurance is automatically paid to the unemployed, offsetting some of the fall in income * Income tax revenues also decrease when income falls in a recession, providing a stimulus to the economy Automatic stabilizers also work in reverse * When the economy expands, government spending for unemployment insurance decreases and taxes increase ] ] --- class: practice-slide # 11. .col-8[ For various reasons, fiscal policy changes automatically when output and employment fluctuate. a. Explain why tax revenues changes when the economy goes into a recession. b. Explain why government spending changes when the economy goes into a recession. c. If the government was to operate under a strict balanced-budget rule, what would it have to do in a recession? Would this make the recession more or less severe? ] ??? a. Tax revenue declines when the economy goes into a recession because taxes are closely related to economic activity. In a recession, people's incomes and wages fall, as do firms' profits, so taxes on these things decline. b. Government spending rises when the economy goes into a recession because more people get unemployment-insurance benefits, welfare benefits, and other forms of income support. c. If the government were to operate under a strict balanced-budget rule, it would have to raise tax rates or cut government spending in a recession. Both would reduce aggregate demand, making the recession more severe. --- ## State Government Finance and Procyclical Fiscal Policy .col-7[ State constitutional provisions mandating balanced budget act as automatic **destabilizers** * During recessions states cut spending and raise taxes * During expansions states increase spending and cut taxes **Procyclical fiscal policy** is changes in government spending and taxes that increase the cyclical fluctuations in the economy instead of reducing them end{itemize} Economists have suggested alternatives to state government procyclical budget policy * States can establish rainy season funds which are reserves kept in good times to offset declines in revenues during recessions * States could use a five-year rolling-average budgeting procedure as the budget they are required to balance ] --- class: practice-slide # 12. .col-8[ How can automatic stabilizers slow an economic recovery? ] ??? Automatic stabilizers increase taxes and reduce expenditures during recoveries without additional government action, which act to slow the recovery. Automatic stabilizers are taxes, social security payments and government expenditure on welfare schemes. An economy is recovering means the average income level of each is increasing, or the cash in hand to spend is increasing because while recovering many unemployed get jobs and new jobs also get created. It decreases the unemployment benefits paid to unemployed and decreases the consumption growth in the economy. In the same way, as the income increases the tax payments increases and reduces the consumption growths which decreases the speed of economic recovery. --- ## The Negative Side of Automatic Stabilizers ![](img12/3502.jpg) .col-7[ When the economy is first starting to climb out of a recession, automatic stabilizers will slow the process, rather than help it along, for the same reason they slow the contractionary process As income increases, automatic stabilizers increase government taxes and decrease government spending, and as they do, the discretionary policy's expansionary effects are decreased ] --- ## Size of the Government Debt Does(n't) Matter .col-7[ Although there is no inherent reason why activist functional finance policies should have caused persistent deficits, increases in government debt have occurred because: * Early activists favored not only fiscal policy, but also large increases in government spending * Politically it's easier for government to increase spending and decrease taxes than vice versa ] --- class: practice-slide # 13. .col-8[ You a running for president of the small nation of Utopia. You promise to cut tax rates, increase transfers and government purchases, reduce the government’s budget deficit, and reduce the government’s debt as a fraction of GDP. If elected, is it possible for you to keep all of your campaign promises in the short run? What about the long run? ] --- ## Fiscal Policy Does(n't) Negatively Affect Other Goals .col-7[ A society has many goals: achieving potential income is only one of those goals National economic goals may conflict For example, when the government runs expansionary fiscal policy, the trade deficit increases 1. New government bonds offer higher return 2. Companies competing for credits must also offer higher returns 3. Foreign investors need the domestic currency, its demand goes up 4. The domestic currency appreciates (it becomes more expensive from the perspective of foreigners) 5. Domestic goods become relatively more expensive on the international market 6. exports decrease, imports increase ] --- class: practice-slide ## 14. .row[.col-9[ If the U.S. government wanted to, it could just say that everyone who is unemployed is “employed in job search” and receiving a paycheck for this “work,” and the government could claim that these government employees are producing “job search services.” Recall that in the official definition of GDP, government purchases (G), do not include transfer payments like unemployment checks and Social Security. ]] .row[.col-6[ a. Would this change in the definition of GDP increase GDP? Would it improve well-being? ] .col-6[ b. If the government permanently defined unemployed people as “employed in job search,” then over the course of a few decades as the economy fluctuated, would GDP look more volatile or less volatile than it does under the regular definition? ]] ??? a. The income approach unlike the expenditure approach, which sums the spending on final goods and services across economic agents (consumers, businesses and the government), evaluates GDP from the perspective of the final income to economic participants. b. GDP would probably be less volatile: During bad times, unemployed people would show up as shifting from private sector work to government work, and during good times, these “government workers” would shift back to the private sector column. Once again, however, well-being would not change. --- # A Drop in the Bucket .col-7[ Normally changes in fiscal policy in terms of percentage of GDP are small. * Most of the non-security discretionary spending is less than 20% of the federal budget. * Stimulus plan passed under President Obama in 2009 -- largest since WWII. * Spread over 3 - 4 years. * At its peak, it was only about 2% of annual GDP. * September 2010: Unemployment rate still high (9.6%) ] --- class: practice-slide # 15. .col-8[ Is fiscal policy better to compensate real shocks or aggregate demand shocks? ] --- ## Fiscal policy does not work well to combat real shocks .row[ .col-6[ ![](img12/f3705.jpg) ] .col-6[ * Real shocks reduce the productivity of labor and capital -- Solow growth curve shifts to the left. * Government responds by increasing their spending. * Because the economy is at full employment most of the increase in government spending will crowd out private spending. * Most of the effect shows up as higher inflation ]] --- class: practice-slide # 16. .col-8[ Use the AS/AD model to explain why most presidents advocate government spending programs when running for reelection. ] ??? Increasing government spending shifts out aggregate demand and thereby increases income and reduces unemployment. This makes people better off in the short run and more likely to vote for the incumbent president. The exception would be if the economy is above potential income and there is a significant inflation threat. --- class: practice-slide # 17. .col-8[ Why doesn’t the government run surpluses every year instead of deficits? Wouldn’t doing so be better for the economy? ] ??? It is much easier for elected officials to cut taxes and increase spending than to do the opposite. --- # Fiscal Policy Might Make Matters Worse .row[.col-7[ If expansionary fiscal policy is paid for by borrowing... * Taxes will rise in the future. * Higher future taxes will contract the economy. Ideal fiscal policy will increase AD in bad times and pay off the debt in good times. But: Governments usually operate like this... * Increase spending in bad times. * Increase spending in good times. * Result: Rising debt ] .col-5[ When the debt is large, interest payments on become a large fraction of the budget. * In extreme situations, additional government borrowing can lead to economic collapse. * Example: Argentina, Greece, Thailand, Mexico, Indonesia.... And many more. `\(\Rightarrow\)` Government debt rose to compared to GDP. * Countries are in danger of defaulting on their debt. * Drives investment away from these countries, and causes all sorts of larger ramifications. ]] --- # Summary: Fiscal Policy is best... .col-7[ * When the economy needs a short-run boost, even at the expense of the long run * When the problem is a deficiency in aggregate demand rather than a real shock * When many resources are unemployed ] --- # Modern Macro Policy Precepts .row[ .col-6[ The modern macro policy precept is a blend of functional and sound finance * Modern economists' suggestion of government policy in a recession is to do nothing in terms of specific tax or spending policy, but let the automatic stabilizers in the economy do the adjustment * If the economy is falling into a severe recession or depression, then the government should run expansionary fiscal policy ] .col-6[ Indeed, the general agreement of economists today is that: * If the economy is headed toward a depression, the appropriate fiscal policy is functional finance; fiscal policy should be expansionary * If the economy is headed toward hyperinflation, the appropriate fiscal policy is functional finance; fiscal policy should be contractionary; government should be running surpluses and paying off debt * If the economy is in normal times, the appropriate fiscal policy is sound finance; balance the budget ]]