University of Illinois at Urbana Champaign Department of Economics Econ 303 Intermediate Macroeconomics Lecture Note 5 Prof Ricardo Bebczuk Fall 2024 Short Run Macroeconomics Who Spends s r o t c e S l a n o i t u t i t s n I Households Businesses Government Rest of the World Fiscal spending and revenues Fiscal Policy Topics Fiscal Multiplier Fiscal Procyclicality Fiscal Imbalances and Debt Measures and International Data A Couple of Fiscal Policy Controversies The Fiscal Multiplier The Circular Flow of Income Employment Income Output Spending Fiscal Multiplier Keynesian assumption and common knowledge The fiscal multiplier Y G is much larger than 1 This fiscal optimism may lead to excessive confidence about a Fiscal policy as an instrument for economic stabilization b Fiscal expansions transfers tax cuts pay by themselves Example G rises by 1 the multiplier is 3 and the income tax rate is 35 Y 3 G 3 1 3 T 0 35 Y 0 35 3 1 05 Y C I G X M The Fiscal Multiplier Y c0 c1 Y i0 i1 Y G X m0 m1 Y Y c0 i0 m0 G X c1 i1 m1 Y Y c1 i1 m1 Y c0 i0 m0 G X 1 c1 i1 m1 Y c0 i0 m0 G X 1 c1 i1 m1 c0 i0 m0 G X Fiscal Multiplier 1 c1 i1 m1 Y C I G X M What Explains the Size of the Fiscal Multiplier Among other things the multiplier will be lower the lower The marginal propensity to consume or the higher the marginal propensity to save s1 1 c1 The marginal propensity to invest i1 The negative of marginal propensity to import m1 that is the higher m1 the smaller the multiplier The degree of Ricardian Equivalence because the private sector saves and offsets totally or partially the fiscal expansion The stronger the automatic stabilizers for example the unemployment insurance and every income linked tax such as the income tax itself The output gap the distance between actual and potential GDP The initial level of public debt and sovereign spread before the fiscal expansion as measures of the likelihood of crisis and greater uncertainty What s the Empirical Value of the Fiscal Multiplier Anyway Before going into that keep in mind that a precise measurement of the multiplier cannot just rely on getting national account numbers on G and Y Why Because that would suppose that everything else remains the same which is never the case The only way you can control the environment for your experiment is in a lab The economy encompasses million of people making and changing their decisions so the lab approach is a no go At most we can run randomized experiments A trio of researchers Banerjee Duflo and Kremer were awarded the 2019 Nobel Prize for their contributions to this branch of empirical economics Still other more conventional but very advanced econometric tools are used to measure the value of the multiplier What s the Empirical Value of the Fiscal Multiplier Anyway In the case of the multiplier there are several elements that affect its value For example do people anticipate the fiscal expansion Does the monetary policy react at the same time What population groups are directly targeted This calls for sophisticated econometric methods Also remember that there are multiple rounds see the circular flow of income so the short run effect should be lower than the long run effect after several quarter has passed OK now based on a large number of papers what s the range of estimates for the long run fiscal spending multiplier It s rather low Long run fiscal spending multiplier 0 6 1 Source Ramey 2019 https pubs aeaweb org doi pdfplus 10 1257 jep 33 2 89 Stimulus Checks in 2020 How Much was Spent and How Much Saved Source https www nber org digest oct20 most stimulus payments were saved or applied debt Fiscal Multiplier in Argentina Does a low multiplier mean that fiscal policy FP is ineffective And what if the multiplier is zero or negative Y C I G X M If 0 Y G 1 FP has low but still positive effectiveness due to the crowding out of private spending private C and I Source Puig 2014 with quarterly data for the period 1993 2012 https econpapers repec org article lapjournl 594 htm Fiscal Procyclicality Countercyclicality Optimal fiscal behavior over the economic cycle GDP Lower government spending and higher tax pressure needed Higher government spending and lower tax pressure needed Years How Should Fiscal Policy Be Administered Fiscal procyclicality is said to be procyclical when public spending goes up during GDP expansions and goes down during GDP contractions A sensible fiscal policy should be like a sensible household budget planning Saving in good times Dissaving in bad times Hope for the best but prepare for the worst Why is procyclicality so bad Because it amplifies macroeconomic fluctuations overheating the economy in upswings and cooling it off in downswings fiscal policy should smooth cycles As society delegates power in the state to do what us individuals won t we expect governments to step up when we re in trouble and just stay out but alert otherwise Fiscal Authorities as Firefighters No Fire Season Good Economic Times Fiscal Authorities as Firefighters Fire Season Bad Economic Times Fiscal Authorities as Firefighters What if this happens during No Fire Season About the Economic and Social Importance of Fiscal Countercyclicality around Crises Biden Package during the 2020 2021 Pandemic About the Economic and Social Importance of Fiscal Countercyclicality around Crises Biden Package during the 2020 2021 Pandemic Source https www brookings edu blog up front 2021 01 28 the macroeconomic implications of bidens 1 9 trillion fiscal package About the Economic and Social Importance of Fiscal Countercyclicality around Crises Fiscal Support as a of GDP during the 2020 2021 Pandemic US UK Australia Japan Canada Germany Italy France Spain Korea Emerging 25 5 19 3 18 4 16 7 15 9 15 3 10 9 9 6 8 4 Low Income 2 7 6 4 3 7 5 0 0 0 10 0 15 0 20 0 25 0 Source Own elaboration based on https www imf org en Topics imf and covid19 Fiscal Policies Database in Response to COVID 19 Note this fiscal support financial measures loan guarantees capital injections that were widely used and can be found in the same database A Good Example of Fiscal Countercyclicality Fiscal primary balance as a of GDP around the Pandemic Source IMF September 2023 https content govdelivery com accounts USIMF bulletins 36ec5db Why Is Fiscal Policy Procyclical in Some Countries In good times Fiscal Voracity Authorities have incentives to spend as much as posible There is always an unmet demand for public spending subsidies health education infrastructure