Fiscal Policy

1
Fiscal Policy

• ECN 111 Macroeconomic Principles
• Instructor Igor Lukashin Spring 2000
• Lecture 18.

2
Fundamental Questions

• What IS fiscal policy?
• How can fiscal policy eliminate GDP gap?
• How has U.S. fiscal policy changed over time?
• What are the effects of budget deficits?
• How does fiscal policy differ across countries?

3
Macroeconomics Government

• Macroeconomic performance is essential in
  presidential campaigns
• Misery Index Unemployment Inflation rates
• Carter vs. Ford, Reagan vs. Carter
• Recession of 1991 cost Bush 1992 re-election
• Government is responsible by law for the
  macroeconomic health of the nation
• Employment Act of 1946
• Federal government is responsible to foster and
  promote free competitive enterprise and the
  general welfare
• Fiscal policy one of governments tools
• government spending and taxation

4
Fiscal Policy and GDP Gap

• Recall that
• GDP Gap potential real GDP - actual real GDP
• How much must the spending rise to reach the
  potential real GDP?
• The required change in spending is called
  recessionary gap, and it equals
• GDP Gap/Spending multiplier
• If G increases by the amount of recessionary gap,
  equilibrium level of GDP would be at its potential

AE
Recessionary Gap
AE
GDP Gap
AEa0
Real GDP
45o
Yep
Ye0
5
Taxation vs. Spending

• Government Spending
• a part of aggregate expenditures gt directly
  affects aggregate demand
• Taxation
• is not a part of aggregate expenditures
• affects aggregate demand indirectly
• through change in disposable income and
  consumption

6
Shifting the AD Curve
Changes in G or T shift AD By changing G or T,
policy makers can affect the real GDP Multiplier
effects Larger when price level stays the
same Smaller when prices rise in response to AD
increase AS is vertical at the potential level
of real GDP (why?) When in a business cycle is
fiscal policy more effective?
7
Financing the Government Spending

• Where does the government get the money?
• Government Spending taxes change in
  government debt change in government-issued
  money
• Taxes
• Higher taxes reduce incentives to work, decrease
  AS
• Laffer curve relationship between the tax rate
  and tax revenue collected
• Borrowing
• Ricardian equivalence Taxation Borrowing
• Monetary Emission (part of monetary policy)

8
Spending financed by taxation

• Increasing taxation spending by the same amount
  shifts AD right
• G shifts AD right for the full amount
• T shifts AD left for a fraction (MPC)
• But, increased taxation reduce incentive to work
  (or to invest), so AS shifts left
• starting at point A, increased G to shift AD1 to
  AD3. However, AS decreased, and new equilibrium
  GDP is only 600 (not 700)

9
Taxation the Laffer Curve

• Supply-side economics
• emphasis on the effects of taxation on aggregate
  supply
• 100 tax - nobody wants to work, nothing is
  produced, tax revenue is 0
• What is the optimal level of taxation?
• What tax rate maximizes tax revenues?

10
Government Spending Financed by Borrowing

• Borrowing
• Sell bonds
• Bonds mature and need to be repaid
• Repaid with what?
• Higher future taxes
• Consumers expect that
• Ricardian Equivalence
• taxation government borrowing have the same
  effect on private sector spending

• Government borrowing affects private sector
  investment through
• Crowding-Out
• Government borrows
• Interest rates rise
• Investment Falls
• Consumption falls as saving increases
• Private sector expenditures fall as a result of
  increase in government spending

11
The Making of U.S. Fiscal Policy

• Federal agencies submit requests to OMB, which
  sends budget guidelines to the President
• Presidents submits recommended budget to congress
• Congressional budget office and committees
  analyze and pass it

• The budget gets reconciled by all committees, and
  then
• Congress appropriates funds
• Fiscal year October 1 through September 31
• Budgeting process takes about 14 months (April
  through June)

12
Fiscal Policy Historical Record

• In 1997, the average taxpayers share of
  national debt was 47k
• Discretionary fiscal policy
• changes in G T aimed at achieving a policy goal
• Automatic Stabilizers
• elements of fiscal policy that change
  automatically as income changes
• Taxes welfare benefits

• Real Expenditures revenues increased steadily
  in the past century
• Expenditures as a of GDP peaked at 45 in 1945,
  dropped to 12 by 50, and been between 15 and 24
  in the last 50 years

13
Effects of Budget Deficits

• Interest Rates Investments
• Government borrows, interest rate rises,
  investment falls
• Lowers output both today in the future (why?)
• International Trade
• Interest rate rises, foreigners buy US government
  bonds
• Demand for US dollars rises, US Dollar
  appreciates
• US Dollar appreciates, Net Exports drop
• Interest Payments on the National Debt
• Debt owned domestically no change in domestic
  wealth
• Foreigners own 30 of US National Debt
• American taxpayers have to pay interest on the
  debt decrease in domestic wealth but what are
  the monies spent on? (why matters?)

14
Automatic Stabilizers

• Taxation (used lump-sum taxes so far)
• Progressive (automatic stabilizer)
• tax whose rate rises as income rises
• Proportionate
• tax whose rate stays the same as income rises
• Regressive
• tax whose rate falls as income rises
• Transfer payment
• a payment to one person that is funded by taxing
  others
• Food stamps, welfare benefits, unemployment
  benefits
• Increase during recessions, fall during expansions

15
Fiscal Policies of Different Countries

• Government Spending
• Grown as a of GDP in all developed countries
  overtime
• US 22, France 45, UK 40, Germany 32
• Allocation differs between developed and
  developing countries
• A major source of investment projects in
  developing countries
• Taxation
• Direct (on inviduals/firms) and indirect (goods
  services)
• Value-added taxes 61-65 of all taxes
• Remember, Homework 3 due April 7!