Chapter 13 Fiscal Policy

1. Chapter 13Fiscal Policy

2. Introduction In response to the economic downturn of 2008-2009, Congress passed the American Recovery and Reinvestment Act (ARRA) as an attempt to stimulate total planned expenditures through additional government spending. Although large portions of the federal funds authorized by ARRA were allocated to states, states spent no more than 5 percent of the total ARRA funds they received. This chapter will help you explore the questions of what the government hoped to accomplish through ARRA and why states spent only a small fraction of their funds.

3. Learning Objectives • Use traditional Keynesian analysis to evaluate the effects of discretionary fiscal policy • Discuss ways in which indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions • Explain why the Ricardian equivalence theorem calls into question the usefulness of tax changes

4. Learning Objectives (cont'd) • List and define fiscal policy time lags and explain why they complicate efforts to engage in fiscal “fine tuning” • Describe how certain aspects of fiscal policy function as automatic stabilizers for the country

5. Chapter Outline • Discretionary Fiscal Policy • Possible Offsets to Fiscal Policy • Discretionary Fiscal Policy in Practice: Coping with Time Lags • Automatic Stabilizers • What Do We Really Know About Fiscal Policy?

6. Did You Know That ... • The U.S. government’s American Recovery and Reinvestment Act of 2009 entailed a greater overall expenditure of funds than the eight-year-long Iraqi conflict? • In this chapter, you will learn about how variations in government spending and taxation affect both real GDP and the price level.

7. Discretionary Fiscal Policy • Fiscal Policy • The discretionary changing of government expenditures or taxes in order to achieve national economic goals, such as: • High employment (low unemployment) • Price stability • Economic growth

8. Discretionary Fiscal Policy (cont'd) • An increase in government spending will stimulate economic activity • Changes in government spending: • Military spending • Education spending • Budgets for government agencies

9. Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a)

10. Figure 13-1 Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (b)

11. Discretionary Fiscal Policy (cont'd) • Questions • Would the increase in government spending equal the size of the gap? • What impact would expansionary fiscal policy have on the price level?

12. Policy Example: Net Real GDP Effect of “Cash-for-Clunkers” Spending: Zero • In 2009, the U.S. government offered $3,500 to $4,500 to people who surrendered used cars and bought new vehicles. • This program aimed to remove high-pollution vehicles from the roads and to increase private expenditures on new cars and trucks. • Economic research suggests that the Cash-for-Clunkers program shifted the timing of vehicle purchases, but that it did not increase the total expenditures on cars and trucks. Consequently, it was not a very effective fiscal stimulus.

13. Discretionary Fiscal Policy (cont'd) • Change in taxes • A rise in taxes causes a reduction in aggregate demand because it can reduce consumption spending, investment expenditures, and net exports

14. Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a)

15. Figure 13-2 Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (b)

16. Discretionary Fiscal Policy (cont'd) • Question • What would be the long-run impact of a tax cut on real GDP if the economy is at full-employment equilibrium?

17. Possible Offsets to Fiscal Policy • Fiscal policy does not operate in a vacuum and important questions must be answered • How are expenditures financed and by whom? • If taxes are increased what does government do with the taxes? • What will happen if individuals worry about increases in future taxes?

18. Possible Offsets to Fiscal Policy (cont'd) • Crowding-out effect • The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector • This decrease normally results from the rise of interest rates

19. Figure 13-3 The Crowding-Out Effect, Step by Step

20. Figure 13-4 The Crowding-Out Effect

21. Possible Offsets to Fiscal Policy (cont'd) • Ricardian Equivalence Theorem • The proposition that an increase in the government budget deficit has no effect on aggregate demand • Reason: people anticipate that a larger deficit today will mean higher taxes in the future and adjust their spending accordingly

22. Possible Offsets to Fiscal Policy (cont'd) • Permanent income hypothesis • The theory of consumption known as the permanent income hypothesis asserts that an individual’s current consumption depends on anticipated lifetime income. • Therefore, a temporary tax cut will have a restrained effect on aggregate consumption.

23. Possible Offsets to Fiscal Policy (cont'd) • Direct Expenditure Offsets • Actions on the part of the private sector in spending income that offset government fiscal policy actions • Any increase in government spending in an area that competes with the private sector will have some direct expenditure offset

24. What If . . . The federal government seeks to boost real GDP by funding health care spending that people had already planned to do on their own? • In recent years, the U.S. government has shifted a larger share of discretionary expenditures toward construction of more public hospitals and clinics. • Although some private health care companies had originally planned to expand their facilities, the federally-funded projects caused the plans for private facilities to be cancelled. • The result was a direct fiscal offset.

25. Possible Offsets to Fiscal Policy (cont'd) • The supply-side effects of changes in taxes • Expansionary fiscal policy could involve reducing marginal tax rates • Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more • The increased productivity will lead to more economic growth

26. Possible Offsets to Fiscal Policy (cont'd) • Supply-side effects of changes in taxes • Lower tax rates lead to an increase in productivity because individuals will work harder and longer, save more, and invest more • Increased productivity will in turn lead to more economic growth, thus higher real GDP • Results: Lower marginal tax rates will not necessarily reduce tax revenues due to a larger tax base

27. Figure 13-5 Laffer Curve

28. Discretionary Fiscal Policy in Practice: Coping with Time Lags • Question • Is the conduct of fiscal policy as precise as it appears? • Answer • The difficulty is that the conduct of fiscal policy involves a variety of lags.

29. Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) • Time lags • Recognition Time Lag • The time required to gather information about the current state of the economy

30. Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) • Time lags • Action Time Lag • The time required between recognizing an economic problem and putting policy into effect • Particularly long for fiscal policy which requires congressional approval

31. Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) • Time lags • Effect Time Lag • The time it takes for a fiscal policy to affect the economy

32. Discretionary Fiscal Policy in Practice: Coping with Time Lags (cont'd) • Fiscal policy time lags are: • Long – a policy designed to correct a recession may not produce results until the economy is experiencing inflation • Variable in length – they can be from 1-3 years, and the timing of the desired effect cannot be predicted • Because fiscal policy time lags tend to be variable, policymakers have a difficult time fine-tuning the economy

33. Automatic Stabilizers • Automatic orBuilt-In Stabilizers • Changes in government spending and taxation that occur automatically without deliberate action of Congress • The tax system • Unemployment compensation • Welfare spending

34. Automatic Stabilizers (cont’d) • The Tax System • Incomes and profits fall when business activity slows down, and the government’s tax revenues drop as well • Some economists consider this an automatic tax cut, which therefore stimulates aggregate demand

35. Automatic Stabilizers (cont’d) • Unemployment Compensation and Income Transfer Payments • Unemployment compensation reduces changes in people’s disposable income. Their disposable income remains positive, although at a lower level • In a recession, more people are eligible for income transfer payments and do not experience as dramatic a drop in disposable income

36. Automatic Stabilizers (cont’d) • Stabilizing Impact • The key impact of these systems is the ability to mitigate changes in disposable income, consumption, and the equilibrium level of GDP • If disposable income is prevented from falling as much as it otherwise would in a recession, the downturn will be moderated

37. Policy Example: Do Fiscal Policy Effects Vary As Real GDP Rises or Falls? • In looking at the impact of discretionary fiscal policy, economic researchers have found that each additional dollar of non-defense spending boosts real GDP by about $1.10. • The impact of an increase in defense spending is greater. • During a recession, each added dollar of defense spending boosts real GDP by more than $3.50. • During an expansion, each additional dollar of defense expenditure results in a $1.20 increase in real GDP.

38. Figure 13-6 Automatic Stabilizers

39. What Do We Really Know About Fiscal Policy? • Fiscal policy during normal times • Congress ends up doing too little too late to help in a minor recession • Fiscal policy that generates repeated tax changes (as has happened) creates uncertainty

40. What Do We Really Know About Fiscal Policy? (cont'd) • Fiscal policy during abnormal times • Fiscal policy can be effective • The Great Depression—fiscal policy may be able to stimulate aggregate demand • Wartime—during World War II real GDP increased dramatically

41. What Do We Really Know About Fiscal Policy? (cont'd) • The “soothing” effect of Keynesian fiscal policy • Should we encounter a severe downturn, fiscal policy is available • Knowing this may reassure consumers and investors • Stable expectations encourage a smoothing of investment spending

42. You Are There: Why a Federal Stimulus Project Took Time to Provide Stimulus • A portion of ARRA funds were devoted to paying for insulation of private homes. • After an initial attempt to get the insulation project underway, the Detroit agency facilitating this process realized that it hadn’t complied with all of the federal requirements for hiring firms to do the work. • Thus, any stimulus to the Detroit economy was delayed while the agency had to start the hiring process all over again.

43. Issues & Applications: How Federal “Stimulus” Was Swallowed Up by States • Figure 13-7 on the next slide displays: • The cumulative quantity of grants of discretionary funds transmitted from the federal government to state governments since late 2008 • The net stock of borrowing by state governments

44. Figure 13-7 Federal Funds Transmittals to U.S. State Governments and Net Borrowings of State Governments Since 2008

45. Issues & Applications: How Federal “Stimulus” Was Swallowed Up by States (cont’d) • The patterns in the graph suggest that the funds transferred to states were largely used to pay off debts that been incurred in earlier years. • Only about 5 percent of the grants to states were used to finance new projects. • Consequently, there was a 95 percent direct fiscal offset.

46. Summary Discussion of Learning Objectives • The effects of discretionary fiscal policy using traditional Keynesian analysis • Increases in government spending and decreases in taxes increase aggregate demand • Decreases in government spending and increases in taxes decrease aggregate demand

47. Summary Discussion of Learning Objectives (cont'd) • How indirect crowding out and direct expenditure offsets can reduce the effectiveness of fiscal policy actions • Deficits increase interest rates • Some government spending replaces private spending • If the Ricardian equivalence theorem is valid, a tax cut has no effect on total planned expenditures and aggregate demand

48. Summary Discussion of Learning Objectives (cont'd) • Fiscal policy time lags and the effectiveness of fiscal “fine tuning” • The time lags for fiscal policy are the recognition time lag, action time lag, and the effect time lag • The time lags are long and variable • Automatic stabilizers are changes in tax payments, unemployment compensation, and welfare payments that automatically change with the level of economic activity

49. Appendix D: Fiscal Policy: A Keynesian Perspective • The traditional Keynesian approach to fiscal policy differs in three ways from that presented in Chapter 13: • It emphasizes the underpinnings of the components of aggregate demand • It assumes that government expenditures are not substitutes for private expenditures and that current taxes are the only taxes taken into account by consumers and firms • It focuses on the short run and so assumes that as a first approximation, the price level is constant

50. Figure D-1 The Impact of Higher Government Spending on Aggregate Demand