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Fiscal Policy

Fiscal Policy. Discretionary Fiscal Policy. Changes at the option of gov’t For beginning, assume: 1) no effect planned private spending, 2) no effect on AS. Expansionary Fiscal Policy. 1) increase G

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Fiscal Policy

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  1. Fiscal Policy

  2. Discretionary Fiscal Policy • Changes at the option of gov’t • For beginning, assume: 1) no effect planned private spending, 2) no effect on AS

  3. Expansionary Fiscal Policy • 1) increase G • Multiplier effect: GDP jumps; if in horizontal zone, growth output w/o inflation; unemployment falls • 2) reduce taxes • Smaller MPC, greater tax cut necessary for same multiplication ($6.67B $5B AE $20B GDP) • 3) use both • Create budget deficit

  4. AE Recessionary Gap AE C+G+I+XN0 C+G+I+XN1 rGDP 490 510

  5. AS PL AD0 AD1 rGDP

  6. Contractionary Fiscal Policy • Restrain demand-pull inflation • 1) decrease G • Negative multiplier effect • 2) raise T • Reduces S by MPS, reduces C by MPC; greater tax cut than spending cut • 3) combine • Create budget surplus

  7. AE Inflationary Gap AE rGDP 530 510

  8. AS PL AD0 AD1 rGDP

  9. Financing Deficits + Disposing of Surpluses Servicing the Deficit • 1) Borrow crowding out effect reduces private spending reduces expansionary impact • 2) Money creation (monetary policy): both more expansionary and inflationary

  10. Loanable Funds Market Real Interest Rate Slf r1 r Dlf1 Dlf Q Q1 Quantity of Loanable Funds

  11. Budget surplus anti-inflationary? • No: pay down debt buy back bonds money back into money market IR fall more borrowing and spending • Yes: impounding, “lock box”

  12. G or T? • Liberals: increase spending in recessions, raise taxes during expansion • Conservative: tax cuts during recession, cut spending during expansion

  13. Nondiscretionary Fiscal Policy: Built-In/Automatic Stabilizers • Increases deficit during recession, increases surplus during expansion w/o policy change • Direct relationship GDP and net taxes • Transfer payments: “negative taxes” • More progressive (average tax rate: T rev/GDP; direct relationship) more stability • Vs. proportional (constant avg TR) or regressive (avg TR inversely related)

  14. G and T T Surplus G Deficit rGDP More progressive = steeper slope

  15. Economic importance: • 1) Taxes reduce S and AD • 2) Stability benefits from taxes, and the more progressive the better: regressive taxes (State) make the problem worse • Can diminish but not correct major changes eGDP

  16. Actual vs. Full-Employment Budget • Built-in stabilizers mean can’t tell if actual budget deficit/surplus is expansionary/neutral/contractionary • Actual budget more than fiscal decisions about G and T, must also look at level of GDP

  17. T e a G d b Cyclical deficit=cd c GDP y2 GDP y1

  18. Actual ≈ Nominal • Full-employment Budget ≈ Real • Measures budget if economy at full-employment throughout year • Structural deficit: reflects configuration G and T independent of GDP • Discretionary fiscal policy deliberate changes in full-employment deficit • Actual = Structural + Cyclical • Structural tells if budget expansionary/neutral/contractionary

  19. Balanced Budget Amendment • Effectively eliminate fiscal policy • Would lead to worsening recessions: • 1) Increase T • 2) Reduce G • 3) Combination •  contractionary

  20. T2 T1 a G1 b GDP y2 GDP y1

  21. T1 G1 a G2 b GDP y2 GDP y1

  22. Fiscal Policy Problems Timing • 1)Recognition lag • Indicators hard to read/slow to appear • 2) Administrative lag • Talk, talk, talk; don’t you wish we lived in a dictatorship? • 3) Operational lag • Tax changes take effect faster

  23. Political • Stability not sole goal • Employment Act 1946 • War, equality, equity, anti-discrimination, etc. • State and Local gov’t • Pro-cyclical • Expansionary Bias • And taxes bad • Political Business Cycle • Short-term memory: 2-3 year cycles of tax cutting and gov spending (pre-election) followed by tax hikes and budget balancing • Not fully supported by evidence

  24. Criticisms of Crowding-Out Effect • Effect during recession limited improved profit expectations may offset higher IR • Monetary policy: “accommodative” monetary policy (expand M) reduce effect (1960s); “tight” (hold M steady) increase effect (1980s)

  25. Aggregate Supply and Inflation • Fiscal policy that pushes AD into intermediate range output “dissipated” into inflation

  26. FP in Open Economy • Globalization may increase fluctuations, certainly complicates fiscal policy • AD shocks: unexpected growth foreign consumers causes overshot of FP

  27. Intended Expansionary Policy AS PL AD0 AD1 rGDP

  28. Actual Effect w/AD Shock AS PL AD2 AD0 AD1 rGDP

  29. AD shocks could also cause overshot of contractionary policy • Could theoretically correct for timing problems

  30. Net Export Effect • Expansionary policy crowding-out higher IR increased foreign financial capital in US (higher rate of return for creditor) higher demand US $ (required for investment) appreciation (higher value US $) US goods more expensive abroad lower net exports reduces expansion, offsetting FP • Contractionary policy has opposite effect • However: lower/higher foreign input prices shifts AS, offsetting effect

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