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Demand Management Policy: The Fiscal Approach. Chapter 11. Introduction. The multiplier model highlights the role of aggregate demand management policies. These include monetary policy and fiscal policy. Introduction.

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introduction
Introduction
  • The multiplier model highlights the role of aggregate demand management policies.
  • These include monetary policy and fiscal policy.
introduction3
Introduction
  • Fiscal policy – the deliberate change in either government spending or taxes to stimulate or slow down the economy.
introduction4
Introduction
  • Expansionary fiscal policy involves decreasing taxes or increasing government spending.
  • Contractionary fiscal policy involves increasing taxes or decreasing government spending.
the story of fiscal policy
The Story of Fiscal Policy
  • An economy needs a countershock to get out of a deep recession.
  • Countershock – a jolt in the opposite direction of the shift in aggregate demand to get the multiplier working in reverse.
the story of fiscal policy6
The Story of Fiscal Policy
  • Individuals, as individuals, are often not prepared to increase their spending during a recession.
  • Collective action may be needed.
the story of fiscal policy7
The Story of Fiscal Policy
  • With fiscal policy, government could provide the needed increased spending by decreasing taxes, increasing government spending, or both.
  • The multiplier would then take over and expand the effect of the initial spending.
aggregate demand management
Aggregate Demand Management
  • Aggregate demand management is government's attempt to control the aggregate level of spending in the economy.
aggregate demand management9
Aggregate Demand Management
  • Demand management is necessary because the effects are significantly different when one person does something rather than everyone doing the same thing.
aggregate demand management10
Aggregate Demand Management
  • Keynesians argued that, in times of recession, spending is a public good that benefits everyone.
fighting recession expansionary fiscal policy
Fighting Recession: Expansionary Fiscal Policy
  • The economy is below potential income during a recession.
  • There is a recessionary gap.
    • Recessionary gap – the difference between equilibrium income and potential income when potential income exceeds equilibrium income.
fighting recession expansionary fiscal policy12
Fighting Recession: Expansionary Fiscal Policy
  • Fighting recession requires expansionary fiscal policy.
  • Assuming that government knows the value of the multiplier, the right amount of money could be injected into the economy.
fighting recession expansionary fiscal policy13
Fighting Recession : Expansionary Fiscal Policy
  • When multiplied, the increase in aggregate demand closes the recessionary gap.
fighting a recession fig 11 1 p 263

LRAS

LRAS

AE1

AE0

Initial AE

increase

G = $60

Multiplier

effect

$60

$120

SAS

E1

AD’1

AD0

AD1

Recessionary gap = $180

$180

$1,000

$1,180

$1,000

$1,180

Fighting a Recession, Fig. 11-1, p 263

E2

Real aggregate expenditures

Price Level

AE = 333 + 0.67Y

mpc = 0.67

0

0

Real income

Real income

fighting inflation contractionary fiscal policy
Fighting Inflation: Contractionary Fiscal Policy
  • When inflation begins to accelerate beyond potential output, fiscal policy works in reverse by decreasing expenditures that are too high.
  • Fighting inflation requires contractionary fiscal policy.
fighting inflation contractionary fiscal policy16
Fighting Inflation: Contractionary Fiscal Policy
  • If the quantity of aggregate demand exceeds potential income at that price level, there will be excess demand and pressures for inflation.
fighting inflation contractionary fiscal policy17
Fighting Inflation: Contractionary Fiscal Policy
  • Output may temporarily exceed potential output because firms and workers may be slow to raise prices and wages.
  • Soon shortages and accelerating inflation will drive the economy back to its potential income.
fighting inflation contractionary fiscal policy18
Fighting Inflation: Contractionary Fiscal Policy
  • Government should decrease its expenditures by an amount that reflects the magnitude of the multiplier.
fighting inflation contractionary fiscal policy19
Fighting Inflation: Contractionary Fiscal Policy
  • This expenditure reduction would remove the inflationary gap.
  • Inflationary gap – the difference between equilibrium income and potential income when equilibrium income exceeds potential income.
fighting inflation fig 11 2 p 264

LRAS

LRAS

AE0

AE1

B

P2

G = $200

SAS1

P1

A

P0

SAS0

Inflationary gap = $1,000

AD0

AD1

$4,700

$5,000

$ 5,000

Fighting Inflation, Fig. 11-2, p 264

E1

Real aggregate expenditures

Price Level

AE = 800 + 0.8Y

E2

mpc = 0.8

$4,000

Real income

$ 4,000

Real income

the questionable effectiveness of fiscal policy
The Questionable Effectiveness of Fiscal Policy
  • There are two ways to think about the effectiveness of fiscal policy – in the model and in reality.
the questionable effectiveness of fiscal policy22
The Questionable Effectiveness of Fiscal Policy
  • The effectiveness of fiscal policy in reality depends on the government's ability to perceive a problem, and react appropriately to it.
the questionable effectiveness of fiscal policy23
The Questionable Effectiveness of Fiscal Policy
  • If the model is correct in describing the economy, and if government acts quickly enough in a countercyclical way, depressions can be avoided.
the questionable effectiveness of fiscal policy24
The Questionable Effectiveness of Fiscal Policy
  • A countercyclical fiscal policy is one in which the government offsets any shock that would create a business cycle.
the questionable effectiveness of fiscal policy25
The Questionable Effectiveness of Fiscal Policy
  • Fine tuning is the term used to describe a fiscal policy designed to keep the economy always at its target or potential level of income.
the questionable effectiveness of fiscal policy26
The Questionable Effectiveness of Fiscal Policy
  • All economists now recognize that the dynamic adjustment in the economy is extraordinarily complicated, especially when taking into account reasonable expectations of future policy.
alternatives to fiscal policy
Alternatives to Fiscal Policy
  • Changes in autonomous C, I, G, X, or IM can achieve the same results as fiscal policy.
  • Changes in any of the five can achieve the same results as fiscal policy.
alternatives to fiscal policy28
Alternatives to Fiscal Policy
  • Any policy that can change autonomous expenditures without having offsetting effects on other expenditures can be used to influence the direction and movement of aggregate income.
alternatives to fiscal policy29
Alternatives to Fiscal Policy
  • There are three alternatives to fiscal policy:
  • Directed investment policies.
  • Trade policies.
  • Autonomous consumption policies.
directed investment policies policy affecting expectations
Directed Investment Policies: Policy Affecting Expectations
  • Directed investment policies are those affecting expectations to increase investment.
directed investment policies policy affecting expectations31
Directed Investment Policies: Policy Affecting Expectations
  • A numerical example:
  • By how much must autonomous investment increase, if income is $400 less than desired and the mpc is 0.5?
  • Working backward, the multiplier is 2, so autonomous investment must increase by $200.
directed investment policies policy affecting expectations32
Directed Investment Policies: Policy Affecting Expectations
  • Directed investment policies include rosy scenario policies and financial guarantees.
rosy scenario
Rosy Scenario
  • Rosy scenario policies involve talking the economy well.
  • Almost invariably, government officials paint optimistic pictures as to where the economy is headed.
rosy scenario34
Rosy Scenario
  • These have been called rosy scenario policies—government policies of making optimistic predictions and never making gloomy predictions.
  • Upbeat predications must be credible for rosy scenario policies to work.
financial guarantees
Financial Guarantees
  • Another way to influence investment is to protect the financial system by government guarantees or promises of guarantees.
  • An example would be a government policy preventing bank failures.
financial guarantees36
Financial Guarantees
  • Still another way in which government can influence investment is through influencing the interest rate.
trade policy and export led growth
Trade Policy and Export-Led Growth
  • Any governmental policy that increases autonomous exports and decreases autonomous imports will also have multiplied effects on income.
  • These policies are called export-led growth policies.
trade policy and export led growth38
Trade Policy and Export-Led Growth
  • Export-led growth policies– designed to stimulate exports and increase aggregate expenditures on Canadian produced goods.
trade policy and export led growth39
Trade Policy and Export-Led Growth
  • Alternatively, any policy that will lower imports, such as increasing tariffs, will have the same expansionary effect on income.
trade policy and export led growth40
Trade Policy and Export-Led Growth
  • A numerical example:
  • By how much must net exports increase, if income is $300 less than desired and the mpc is 0.33?
  • Working backward, the multiplier is 1.5, so net exports must increase by $200.
the global economy is interdependent
The Global Economy Is Interdependent
  • If one nation follows an export-led growth policy, it forces other nations into an import-led decline for its economy.
  • It can reasonably be expected that other nations will retaliate against an export-led growth policy.
the global economy is interdependent42
The Global Economy Is Interdependent
  • As a consequence, many economists support free trade agreements such as NAFTA (North American Free Trade Agreement).
exchange rate policies
Exchange Rate Policies
  • The trade balance can also be affected through exchange rate policy.
  • An exchange rate policy deliberately affects a nation’s exchange rate in order to affect its trade balance.
exchange rate policies44
Exchange Rate Policies
  • A low value of a country's currency relative to currencies of other countries encourages exports and discourages imports.
  • A high value of a country's currency relative to currencies of other countries discourages exports and encourages imports.
autonomous consumption policy
Autonomous Consumption Policy
  • Autonomous consumption policy is a third alternative.
  • Increasing the availability of consumer credit to individuals increases consumption.
real world examples
Real World Examples
  • The effect of wartime spending in the 1930s and 1940s and the prolonged expansion of the mid-1990s to early 2000s illustrate how fiscal and other expenditure policies work.
fiscal policy in world war ii
Fiscal Policy in World War II
  • Taxes rose during World War II, but government expenditures rose much more.
  • The deficit shot up and real income rose by more than the increase in the deficit.
fiscal policy in world war ii48
Fiscal Policy in World War II
  • But where is the price-level increase one would expect?
  • One would normally expect a huge inflation.
fiscal policy in world war ii49
Fiscal Policy in World War II
  • The wartime expansion was accompanied by wage and price controls and rationing.
fiscal policy in world war ii50
Fiscal Policy in World War II
  • Owing to the death of soldiers and sailors, unemployment was unintentionally reduced.
recent fiscal policy
Recent Fiscal Policy
  • The deficit picture in the 1990s changed from a large deficit to a large surplus.
  • Economic theory would predict a slow down in the economy – but the economy boomed in the mid-1990s.
  • There are two explanations for this seeming paradox.
recent fiscal policy54
Recent Fiscal Policy
  • The contractionary effect of the surplus was offset by booms in consumer and investment spending.
recent fiscal policy55
Recent Fiscal Policy
  • Much of the surplus resulted from the booming economy, not from discretionary fiscal policy.
recent fiscal policy56
Recent Fiscal Policy
  • Much of the deficit reduction and movement into budget surplus resulted from an increase in income.
recent fiscal policy57
Recent Fiscal Policy
  • The economy exceeded economists' estimate of potential income, without generating inflation, by far more than anyone thought.
problems with fiscal and other activist policies
Problems with Fiscal and Other Activist Policies
  • Activist government policy seems so simple:
    • If the economy contracts, the government runs an expansionary fiscal policy.
    • If there's inflation, the government runs a contractionary fiscal policy.
problems with fiscal and other activist policies59
Problems with Fiscal and Other Activist Policies
  • In real life, that is not the way it is.
  • That does not necessarily mean the model is wrong.
  • The model must be modified for it to work in the real world.
problems with fiscal and other activist policies60
Problems with Fiscal and Other Activist Policies
  • The model makes the following assumptions:
  • Financing the deficit doesn't have offsetting effects.
  • The government knows what the situation is.
  • The government knows the level of potential income.
problems with fiscal and other activist policies61
Problems with Fiscal and Other Activist Policies
  • The model makes the following assumptions:
  • The government has flexibility in changing taxes and spending.
  • Size of the government debt doesn't matter.
  • Fiscal policy doesn't negatively affect other government goals.
financing the deficit doesn t have offsetting effects
Financing the Deficit Doesn't Have Offsetting Effects
  • Some economists argue that government financing of deficit spending will offset the deficit's expansionary effect.
  • They object to the multiplier model assumption that savings and investment are unequal.
financing the deficit doesn t have offsetting effects63
Financing the Deficit Doesn’t Have Offsetting Effects
  • These economists believe that the interest rate equilibrates savings and investment, and that government borrowing increases interest rates and crowds out private investment.
financing the deficit doesn t have offsetting effects64
Financing the Deficit Doesn’t Have Offsetting Effects
  • Crowding out is the offsetting of a change in government expenditures by a change in private expenditures in the opposite direction.
financing the deficit doesn t have offsetting effects65
Financing the Deficit Doesn’t Have Offsetting Effects
  • Crowding out occurs because increased government borrowing pushes up interest rates in the economy.
  • Private businesses have to borrow when interest rates are high, so they reduce their borrowing and investment.
financing the deficit doesn t have offsetting effects66
Financing the Deficit Doesn’t Have Offsetting Effects
  • The expansionary effect of increased government spending is reduced by “crowding out” the private investment.
financing the deficit doesn t have offsetting effects67
Financing the Deficit Doesn’t Have Offsetting Effects
  • Some economists argue that the effect of government expenditures is negative, because they consider private spending to be more productive than government spending.
financing the deficit doesn t have offsetting effects68
Financing the Deficit Doesn’t Have Offsetting Effects
  • Crowding out also works in reverse in contractionary fiscal policy.
  • If the government is running a surplus and buys back bonds, interest rates will decline, stimulating investment, thereby causing inflation.
financing the deficit doesn t have offsetting effects69
Financing the Deficit Doesn’t Have Offsetting Effects
  • Some Keynesians argue that often the crowding out will be offset by crowding in.
crowding out and partial crowding out fig 11 4 p 273

AP

AE1 (C + I0 +G1)

AE2 (C + I1 +G1)

Partial crowding out

(I1 – I0)

AE0 (C + I0 +G0)

SAS

DG

Aggregate expenditures

Price level

Partial crowding out

Net effect =

Y2 – Y0

AD0

AD2

AD1

Y0

Y2

Y1

Y0

Y2

Y1

Real output

Crowding Out and Partial Crowding Out, Fig. 11-4, p 273
knowing what the situation is
Knowing What the Situation Is
  • Getting reliable numbers on the economy takes time.
  • We may even be in the middle of a recession and not know it.
knowing what the situation is72
Knowing What the Situation Is
  • The government has large econometric models and leading indicators to predict where the economy will be in the near future.
  • Economic forecasting is still very much an art and not a science.
knowing the level of potential income
Knowing the Level of Potential Income
  • No one knows for sure the level of potential income.
  • Potential income has been called the full-employment level of income.
knowing the level of potential income74
Knowing the Level of Potential Income
  • Differences in estimates of potential income often lead to different policy recommendations.
knowing the level of potential income75
Knowing the Level of Potential Income
  • Okun’s law is general rule of thumb economists use to translate changes in the unemployment rate into changes in income.
  • According to Okun’s lawa1% fall in the unemployment rate is associated with a 2% increase in income.
knowing the level of potential income76
Knowing the Level of Potential Income
  • 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.
the government s flexibility in changing taxes and spending
The Government’s Flexibility in Changing Taxes and Spending
  • Even if all economists agree that an expansionary policy is needed, putting fiscal policy into place takes time and has serious implementation problems.
the government s flexibility in changing taxes and spending78
The Government’s Flexibility in Changing Taxes and Spending
  • Numerous political and institutional realities in Canada today make it a difficult task to implement fiscal policy.
the government s flexibility in changing taxes and spending79
The Government’s Flexibility in Changing Taxes and Spending
  • Squabbles between the Commons and the Senate may delay implementing appropriate fiscal policy for months, even years.
size of the government debt doesn t matter
Size of the Government Debt Doesn’t Matter
  • These is no inherent reason why the adoption of activist policies should have caused high government deficits year after year.
size of the government debt doesn t matter81
Size of the Government Debt Doesn’t Matter
  • Activist policy has led to an increase in government debt because:
  • Early activists favored large increases in government spending as well as favoring the government's using fiscal policy.
  • Politically, it is much easier for government to increase spending and decrease taxes than vice versa.
size of the government debt doesn t matter82
Size of the Government Debt Doesn’t Matter
  • If one believes that debt is harmful, then there might be a reason not to conduct expansionary fiscal policy, even when the model calls for it.
fiscal policy doesn t negatively affect other government goals
Fiscal Policy Doesn’t Negatively Affect Other Government Goals
  • An economy has many goals; achieving potential income is only one of those goals
  • National economic goals often conflict.
summary of the problems
Summary of the Problems
  • While the six problems listed above do not necessarily eliminate fiscal policy altogether, they severely restrict it.
  • Fiscal policy is a sledgehammer, not an instrument for fine-tuning.
fiscal policy when the price level is flexible
Fiscal Policy When the Price Level is Flexible
  • With flexible prices, the short run supply curve is upward sloping.
  • A change in government spending will shift the aggregate demand, and therefore, both income and prices will be affected.
  • Change in the price level will affect the aggregate expenditure.
fiscal policy when the price level is flexible86
Fiscal Policy When the Price Level is Flexible
  • If price level increases, the aggregate expenditure will be reduced.
  • If prices fall, aggregate spending will further increase.
eliminating a recessionary gap when prices are flexible fig 11 5 p 278

LRAS

AP

AE1(P0 )

AE1(P1 )

Real aggregate

expenditure (dollars)

30

Price level

AE0(P0 )

G=90

AD1

AD0

1000

1180

Real output (Y)

Real output (Y)

Eliminating a Recessionary Gap When Prices are Flexible, Fig. 11-5, p 278

SAS

P1

P0

eliminating a inflationary gap when prices are flexible fig 11 6 p 279

AP

LRAS

AE0(P0 )

SAS

AE1(P1 )

Real aggregate

expenditure (dollars)

Price level

AE1(P0 )

250

50

AD0

AD1

Real output (Y)

Real output (Y)

Eliminating a Inflationary Gap When Prices are Flexible, Fig. 11-6, p 279

A

A

P0

B

B

P1

4000

5000

building fiscal policies into institutions
Building Fiscal Policies Into Institutions
  • Economists were quick to realize the political realities of fiscal policy so they attempted to create built-in fiscal policies.
building fiscal policies into institutions90
Building Fiscal Policies Into Institutions
  • These built-in fiscal policies are called automatic stabilizers.
  • Automatic stabilizers are any government program or policy that counteracts the business cycle without any new government action.
building fiscal policies into institutions91
Building Fiscal Policies Into Institutions
  • Automatic stabilizers include welfare payments, unemployment insurance, and the income tax system.
building fiscal policies into institutions92
Building Fiscal Policies Into Institutions
  • Automatic stabilizers have their problems:
  • When the economy first starts climbing out of a recession, automatic stabilizers may slow down the process.
building fiscal policies into institutions93
Building Fiscal Policies Into Institutions
  • Automatic stabilizers have their problems:
  • As income increases, automatic stabilizers increase government taxes and decrease government spending, and as they do, the discretionary policy's expansionary effects are decreased.
building fiscal policies into institutions94
Building Fiscal Policies Into Institutions
  • Despite these problems, most economists believe automatic stabilizers have played an important role in reducing fluctuations in the economy.
decrease in fluctuations in the economy fig 11 7 p 280

Modern

regime

Pre-Keynesian regime

Keynesian regime

Decrease in Fluctuations in the Economy, Fig. 11-7, p 280