Topic 9 Fiscal Policy Agenda What is Fiscal Policy Fiscal Policy as an automatic stabilizer Difficulties implementing Fiscal Policy Balanced Budgets The Laffer Curve Motivating Questions What happens when a government stops spending money Is it possible for a government to always be in debt What is Fiscal Policy Why does the government do anything First a Definition Fiscal Policy Changes in government purchase and or tax collections designed to achieve a full employment and noninflationary domestic output Consider two types 1 Changes in government purchases in Output Markets 2 Change in net transfers What happens to AD Government purchases increase or taxes decrease Government purchases decrease or taxes increase What happens to AD AD Expands Government purchases decrease or taxes increase What happens to AD AD Expands AD Contracts So we have two new definitions 1 Expansionary Fiscal Policy An increase in government purchases or a decrease in taxes or a combination for the purpose of increasing aggregate demand to the fullemployment rate So we have two new definitions 2 Contractionary Fiscal Policy A decrease in government purchases or an increase in taxes or a combination for the purpose of decreasing aggregate demand to the fullemployment rate The GDP Gap GDP Gap Difference between the NRO and the SR equilibrium GDP Gap SReq NRO Price 50 60 GDP Gap 10 Quantity Government wants to increase RGDP by 20 billion Assume MPC 0 5 so fiscal multiplier is 2 Policy choices 1 The Recovery Act Spend our way out 2 Trickle Down cut taxes What if we increase Government Spending Recall ChangeY Multiplier CISOM 20 billion 2 CISOM CISOM 10 billion But ChangeG CISOM So ChangeG 10 billion Note Assumption No Change in I What if we Lower Taxes ChangeY Multiplier CISOM 20 billion 2 CISOM CISOM 10 billion But CISOM MPC ChangeTaxes So ChangeTaxes 10 billion 0 5 20 billion Assumption No Change in I What does this say about balanced budgets Government must reduce spending CISOM1 by 20 billion for a CISOM2 of 10 billion Net CISOM 20 billion 10 billion 10 billion Will reduce GDP not increase it Aside What is the multiplier really Why does this matter Note If mult 1 austerity measures are good Ex Multiplier 0 5 Then decrease in G of 10 only reduces GDP by 5 Can increase RGDP by austerity and tax refunds Current estimate by IMF Oct 2012 Multiplier is between 0 9 and 1 7 in Europe How can it be 1 Monetary policy to be discussed later Aside Effects of Austerity in Europe Automatic Stabilizers sort of like training wheels on a bike Why do we have training wheels on a bike If we tip too far to one side they make sure we don t fall off Fiscal Policy as an automatic stabilizer 1 If economy experiences a boom and everyone makes more money what happens to total tax revenue 2 Assume tax revenues were the same as pre expansion Is GDP higher or lower compared to that in point one In an expansionary phase taxes the economy Fiscal Policy as an automatic stabilizer 1 If economy experiences a recession and everyone makes less money what happens to total tax revenue 2 Assume tax revenues were the same as pre recession Is GDP higher or lower compared to that in point one Definition of Automatic Stabilizer Changes in fiscal policy that stimulate AD when the economy goes into a recession or slows AD when economy goes into a boom without policy makers having to take any deliberate action Other examples Unemployment Insurance Welfare benefits Fiscal Policy Issues Timing Consider trying to order a drink in a busy bar 1 Takes time for the waiter to notice you want a drink 2 Waiter places order but takes time for the bartender to make the drink 3 Takes time for the waiter to bring the drinks from the bar to your table These are Timing Problems 1 Takes time for the waiter to notice you want a drink 2 Waiter places order but takes time for the bartender to make the drink 3 Takes time for the waiter to bring the drinks from the bar to your table These are Timing Problems 1 Recognition Lag takes time to confirm how economy is doing 2 Waiter places order but takes time for the bartender to make the drink 3 Takes time for the waiter to bring the drinks from the bar to your table These are Timing Problems 1 Recognition Lag takes time to confirm how economy is doing 2 Administrative Lag Takes time to pass an economic package 3 Takes time for the waiter to bring the drinks from the bar to your table These are Timing Problems 1 Recognition Lag takes time to confirm how economy is doing 2 Administrative Lag Takes time to pass an economic package 3 Operational Lag Takes time for the stimulus to actually happen money to get to the right places etc Timing is hard Consider a 1year recession Demandpull inflation Recognize Issue 6 months Recession over but spending is increasing Pass Bill 3 months Money goes out 3 months Timing is hard Consider a 1year recession Demandpull inflation Recognize Issue 6 months Recession over but spending is increasing Pass Bill 3 months Money goes out 3 months What is the impact of temporary versus permanent policy decisions World 1 World 2 Government permanently reduces taxes Government reduces taxes for 1 year In which world would you spend more Why What if government claims to be in world 1 but next year reveals we are in world 2 What would you do the next time they introduced a policy claiming to be in world 1 What is the impact of temporary versus permanent policy decisions World 1 World 2 Government permanently increases taxes Government increases taxes for 1 year In which world would you spend less Why What if government claims to be in world 2 but next year reveals we are in world 1 What would you do next time they introduced a policy claiming world 2 Temporary versus Permanent In which worlds then would fiscal policy be more effective in altering RGDP Complete this sentence If people think fiscal policies are then fiscal policy will not have a lot of effect on the economy We have a symmetry problem Issue with government incentives Do you believe tax breaks are permanent Do you believe tax increases are temporary So is a tax break effective at raising GDP What about a one time tax Can you have one without hurting GDP Consider Cyprus One time tax on deposits may permanently reduce GDP by 30 Should we balance the budget Is the government like a household i e live within our means or debt is bad Which world do you prefer World 1 World 2 Week 1 All you can eat buffet for every meal Week 2 Seven day fast i e no
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