TOPIC 4

1. TOPIC 4 The Role of the Government and Fiscal Policy

2. The I-S Curve and Fiscal Policy

3. Some Equations From Lecture 1 • The demand side of the economy: Y = C + I + G + NX • Given the demand side of the economy and definitions for disposable income and government deficits, we have: S(hh) + S(govt) = I + NX S = I + NX • The fourth curve in our class is the “IS” curve. The IS curve is so named because it documents the relationship between “saving” and “investment” on the demand side of the economy (holding NX constant).

4. The IS Curve • The IS curve is the representation of the demand side of the economy drawn in {Y,r} space. • Highlights the relationship between interest rates and aggregate expenditure (Y). • Interest rates affect demand through its affect on investment (I). • Key equation: Y = C(.) + I(.) – dIr + G + NX • Remember: I = I(.) – dI r (given our linearization assumption in Topic 3) • Remember: C= C(.) (given our discussion in Topic 3)

5. Fourth Major Curve of the Course: IS curve • C(.) is a function of PVLR (Y, Yf, W), tax policy, expectations (i.e., consumer confidence), liquidity constraints. (Consumption can be endogenous in model) • I(.) is a function of A, business confidence, liquidity constraints, uncertainty, and investment tax policy. (Total investment is endogenous to our model) • G is a function of government policy (we will discuss this shortly). (G is exogenous in our model.) • NX will be set to zero until Topic 8. • The IS curve relates Y to r. How do interest rates affect Y? • As r falls, Investment increases (due to MPK and firm profit maximization behavior). • IS curve is downward sloping in {r, Y} space.

6. Demand Side Analysis (IS Curve) r r* r* IS Y Y* Suppose r is set by the Fed at the level of r* (we will explore this in depth later in the course). For a given r, we can solve for the level of output desired by the demand side of the economy. Ignore the supply side of the economy for awhile. Will return to it in Topic 6. Note: Y need not equal Y* - I drew it this way for illustrative purposes.

7. Some Thoughts on IS Curve • What shifts the IS curve? Anything that causes C(.), I(.) or G to change (or NX when we model it). • What shifts IS curve to the right? (i.e., makes Y higher on the demand side of the economy) Increase in consumer confidence (expectations of future PVLR) Permanent increase in stock market wealth. A permanent reduction in income taxes (if households are PIH or Keynesean) A temporary reduction in income taxes (if households are Keynesean or Liquidity Constrained PIH). An expected future increase in TFP (stimulates investment demand). An increase in government spending (i.e., war). • Changes in r WILL NOT cause IS curve to shift (causes movement along IS curve).

8. Suppose Consumer Confidence Falls r Suppose consumer confidence falls (and no effect on Y*). IS curve will shift in. C(.) falls r* r* IS1 IS Y Y* Y1 Assume that I(.), NX, and G do not change (all else is equal)

9. Fiscal Policy • Fiscal policy is the use of government spending (G), taxes (tn, tc) and transfers (Tr) to stabilize the economy. • Governments can have: o Output targets o Price targets o Unemployment targets • Stabilizing the economy means moving the economy towards its targets. We will ignore price targets for now (we have no prices in our model yet). • Suppose the government has an output target and suppose that target is Y* (we will also explain why Y* is a good target later in the course). • Fiscal policy then would be the manipulation of G, taxes and transfers to move the economy towards Y*. (Assumes government knows where Y* is - we will discuss other drawbacks to fiscal policy later in the course).

10. Example of Fiscal Policy: Consumer Confidence Falls r Government can undo the decline in consumer confidence by increasing G or decreasing tn - this is fiscal policy C(.) falls r* r* G increases IS1 IS = IS2 Y Y* Y1 Compute Change in G: If ΔG = -ΔC(.), Y will remain unchanged (taking r as fixed)

11. A Look at U.S. Debt and Deficits

12. U.S. Federal Deficit (Relative to GDP)

13. U.S. Federal Budget Deficit (Relative to GDP)

14. U.S. Total Public Debt (Relative to GDP)

15. US Federal Spending 2019

16. U.S. Federal Interest Paid (Relative to GDP)

17. Who Owns U.S. DEbt?

18. The Cyclicality of Government Budget Deficits

19. Some Additional Structure on Taxes and Transfers Let us start with some definitions about debts and deficits. Tax Revenues = tnY (where tn is the marginal tax rate on income) Transfers Payments = Tr – g Y (where g proxies for how transfers go up when aggregate income falls – i.e., welfare transfers are higher in recessions) Rationale for specifications: • When Y increases, tax revenues increase (more earnings in economy). - This is built into the tax code. - You are taxed based upon what you earn. • When Y increases, transfers payments fall (less people on welfare) - This is built into our social programs. - We transfer more money to people when their income is low.

20. Some Deficit Terminology Actual Government Deficits = Outlays (G and Tr) – Revenues (T) = G + Tr – g Y - tnY = G + Tr – (g + tn)Y Note: For now, ignore other government revenues and expenses (like interest on government debt). See text for further discussion if interested. Definition: Structural Budget Deficitis the deficit that would exist if the economy were at Y*: Structural Budget Deficit = G + Tr – (tn + g)Y* Note: Difference between structural deficits and actual deficits is only due to differences between Y and Y*. Cyclical Budget Deficits = Actual Budget Deficits - Structural Budget Deficits. Cyclical deficits occur anytime Y does not equal Y*!

21. The Nature of Deficits • Deficits are countercyclical!(They rise when Y falls and fall when Y rises) • Even if the government has a policy (combination of G and T) that would lead to no deficits at Y* (the target level of output for the economy), deficits could still occur. The reason: Y does not always equal Y*. • Why do we get countercyclical deficits? Welfare Payments, Unemployment Insurance, and Tax System dampen the effects of consumption over the business cycle. • T goes up when times are good (like in the late 1990s). • G/Tr goes up when times are bad (welfare payments). • We refer to such policies that dampen consumption as “automatic stabilizers” • Given “automatic stabilizers” (and potentially proactive governmental fiscal policies), cyclical deficits seem to be an inherent part of our economy.

22. Government Spending at Y* (model preview)

23. Revisiting Potential Output (Y*) • Potential output is the level of output in the economy when the labor market clears • Formally: Y* = A K1-α (N*)α • Where we are heading: o Short run: period of time when the labor market does not clear o Long run: period of time when the labor market clears (given A, K and other inputs). • From topic 2, market clearing N* depends on: o Labor Supply: PVLR, taxes, population, value of leisure o Labor Demand: A and K (and eventually other inputs like oil prices)

24. Increase in G at Y*: Investment Adjusts LRAS = Y =Y*=f(A,K,N*) r1 r* IS = Y=C+I+G Y Y* Suppose we start at Y* such that Y is pinned down by the supply side (i.e., labor markets clear, all resources used efficiently)

25. Increase in G at Y*: Investment Adjusts LRAS = Y =Y*=f(A,K,N*) r1 I r* G IS1 = C+I1 +G1 IS = Y=C+I+G Y Y* Assumption: Assume increase in G has no effect on A (for now) Model: Increase in G has no effect on N* (no effect on labor supply or labor demand (holding A fixed)). So, no effect on Y*.

26. What is the Effect of Running a Deficit at Y*? Situation 1: Crowding Out of Investment: Equation 1: Y = C + I + G Equation 2: SHH + Sgvt = I (if NX = 0) If Y is pinned down by supply side of economy (such that ΔY = 0 if G increases), then either C or I must fall to offset increase in G (i.e., ΔG = - ΔI). Why would I fall? Increase in interest rates (we will prove once we build a model of money market). What is the effect of falling I (due to increased G) on future generations? Lower I today, means lower K tomorrow. Lower K tomorrow means lower Y* tomorrow (lower economic growth). If at Y*, increase in deficit will hurt future generations unless the deficit has a non-trivial effect on A (given Cobb Douglas Production: If %ΔA > 0.3 * %Δ K, then deficit could help future generations.)

27. What is the Effect of Running a Deficit at Y*? Situation 2: Ricardian Equivalence: Adjustment occurs on C as opposed to I (to keep Y at Y*) Definition: Ricardian Equivalence: Theory that states that consumers’ behavior is equivalent regardless of whether the government finances G (govt. expenditures) through increased taxes or through increased debt Key: If the government floats debt to finance the spending today, consumers realize that the government, at some time in the future, will have to raise taxes to pay back the debt. Summary: A reduction in taxes today (or an increase in G today) will be seen as being accompanied by higher taxes in the future. Households will save today to fund the future tax increases (they expect disposable income in the future to fall). National Saving would remain unchanged. In terms of equations: Y is fixed, C falls and Shh goes up (prevents crowding out of investment ; I can stay fixed)

28. Does Ricardian Equivalence Hold? • For the most part, there is little evidence to support the existence of Ricardian Equivalence. Why? Myopia Liquidity Constraints High Levels of Impatience Do not care about bequests/future generations Timing of Taxes is Important (taxes are not lump sum) Even if taxes go up in the future, only adjust savings by small amounts each period. • For the rest of the course, we will assume consumers are “non Ricardian” unless told otherwise. This means that consumers will not adjust their consumption downward today in expectation of an increase in taxes tomorrow. • Ricardian consumers, however, would adjust their consumption downward today in expectation of increases in taxes tomorrow (because PVLR falls) in response to a permanent increase in G.

29. Summary: Effects of Deficit Financed Government Spending at Y* • Benefits: o Can potentially increase future growth if it increases future TFP (think infrastructure spending). o Invest in public goods • Costs: o Crowds out private investment (which hurts future generations) o Have to pay distortionary future taxes (which hurts future generations) o Government spending is often inefficient (which wastes resources) • Caveats: o There is another margin of adjustment in an open economy: borrow from the world. Hurts future generations because some future income will flow out of the country to repay the debt. o Equity issues within current generation may be important – but those are separate from deficit issues. Deficits focus on equity across generations.

30. Should Governments Try To Prevent Deficits? • Examples: U.S. Balanced Budget Amendment. Maastricht criteria for entry to European Economic and Monetary Union (EMU) that deficit/GDP be 3% or less and that debt/GDP be 60% or less. • Benefits: Limit Spending: If spend today, government must: 1) Raise Taxes Now (changing taxes frequently creates economic uncertainty) 2) Raise Taxes in Future (higher taxes cause disproportionately more distortions ) 3) Print Money In Future (could lead to inflation) • Is there a cost? Yes - balanced budget amendments can make economic situations worse. Refer back to the example earlier in this lecture when consumer confidence fell. As Y fell, tax revenues fell. As tax revenues fell, deficits (cyclical) increased. If the government had to balance the budget, they would either have to cut G or increase T - both of which would cause the IS curve to shift further to the left. • Conclusion - it may be bad to have policies requiring governments to eliminate all deficits, but there may be some benefits from eliminating structural deficits.

31. Government Spending During Recessions (Quick Discussion – For Now)

32. Summary: Effects of Deficit Financed Government Spending During Recessions • Benefits: o Can potentially increase future growth if it increases future TFP (think infrastructure spending). o Invest in public goods o Can utilize slack resources in the economy – If economy is below potential, government spending can generate more output. • Costs: o Crowds out private investment (which hurts future generations) o Have to pay distortionary future taxes (which hurts future generations) o Government spending is often inefficient (which wastes resources) • Note: o Other costs and benefits are the same as increasing G at Y*

33. Government Spending Multiplier • Tries to measure the net change in GDP today from a given change in government spending today. • Measured by ΔY/ ΔG • By construction, only includes current GDP o Utilizing slack resources o Crowding out of investment • Ignores potential future costs o Does not include potential effects on future productivity o Does not include effect of potential distortionary tax increase in future • Ignores that slack resources also have value o Slack workers value leisure and slack machines forgo depreciation.

34. How Big Can the Multiplier Be? • In the long run (when Y = Y*), the multiplier is zero o Interest rates adjust and crowds out investment o Output is pinned down by the supply side of the economy • When economy is below Y* (recession), the multiplier can be significant o Slack resources are utilized o Interest rate effect is smaller such that investment is not perfectly crowded out. o Output determined – in part – by demand side of the economy. • This simple model underlies the “Keynesian” intuition often seen in the popular press advocating increased government spending during recessions.

35. A Simple Model of a Government Spending Multiplier • Focus on demand side only (no link to supply side) • Assume interest rates do not adjust to change in government spending o A crazy assumption (we will model interest rates next week). o Not so crazy when interest rates are “stuck” at zero (what economists call the Zero Lower Bound). o Ignoring interest rate changes assumes away the crowding out of investment. • Assume consumers do not adjust spending to changes in government spending. o Implies consumers are not Ricardian.

36. Why is There a Potential “multiplier” When Y < Y*? Suppose we have the following model: C = a + b(Y – T) << assume some fraction of consumers are liquidity constrained so they act Keynesian>> I = I0 – I1 r <<Investment is negatively related to interest rates>> T = tn Y <<Marginal tax rate on labor income>> Other assumptions: Transfers = 0 ; G = G0 ; Y << Y* ; closed economy (NX = 0 always) What is the equilibrium level of Y? Y = C + I + G = a + b(Y – tnY) + I0 – I1 r + G0 Solve for Y (Use algebra – one equation, one unknown) Y = [a + I0 – I1 r + G0] / [1-b(1-tn)]

37. What is the private sectormultiplier in the Simple Model? Given the Simple Economy on Previous Page: Y = [a + I0 – I1 r + G0] / [1-b(1-tn)] What is the multiplier of a change in government spending (G) on Y? dY/dG = 1/[1-b(1-tn)] What is b? Some estimates range from 0.3-0.4 in recession. Where are the estimates from? -- Micro data analyzing tax rebates (a change in taxes not a change in government spending). What is t? Marginal tax rate – roughly 0.25-0.35 What is the government spending multiplier in this simple model? dY/dG is approximately 1.3 (if b = 0.35, t=0.3)

38. The Simple Keynesian Multiplier • Upper bound on the true (or net) government spending effect on output. o Ignores the crowding out of investment by holding interest rates fixed. o Ignores consumer responses by imposing Ricardian equivalence. o Ignores any supply side effects (prices may adjust – more on that when we build a model of prices). • Government spending multipliers will be higher in recessions o More slack resources can be mobilized without “crowding out” investment.

39. Estimated Government Policy Multipliers in the Data • Typically estimated by looking at correlation between G and Y in time series data. o Difficult because government mainly tries to stimulate economy in recessions (build in negative correlation) o However, need to focus on government spending in recessions because multipliers are different when Y=Y* and Y < Y*. o Hard to do proper counterfactuals • Two famous papers using “wars” as instrument: o Christy Romer: 1.6; Robert Barro: 0.6. • Some recent studies look at state-level spending o Large multipliers; 1.5 - 2.0 o But, by construction, no interest rate response (no crowding out)

40. My Thoughts • In the long run, multiplier close to zero o Output determined by supply side of the economy o Most government spending does not increase TFP • In recessions, multiplier positive but likely small o Output determined by demand side of economy (utilizes idle resources) o But typically interest rates adjust, so investment partially crowded out. o Also, inefficiencies likely to be huge – how do you spend $800 billion quickly and efficiently? • Often a mismatch between “slack resource effect” and “increasing TFP effect” o Lots of slack resources in Detroit. Do we need more roads in Detroit?

41. Tax Cuts During Recessions • Another way to stimulate the economy during recession is cut taxes o Consumption: labor income taxes, consumption taxes o Investment: corporate income taxes, investment tax credits • Common view is that tax cuts are less effective at stimulating GDP (for a given $1 increase in deficit) o Lower bang for buck o Do not get direct effect of government spending • Recent research says they can be still somewhat effective: o Tax rebates to households (C) o Firms are very responsive to bonus depreciation allowance (I) • Different efficiency trade-offs (less wasteful, no direct effect on TFP)

42. Definition: Supply Side Economics

43. Supply Side Economics Any fiscal policy designed to stimulate the supply side of the economy (A, K and N) Examples: 1) Changing marginal tax rates (stimulate N) As discussed before , these policies may not have big effects (off setting income effects and substitutions effects ; empirically small estimates of labor supply response). 2) Subsidizing A and K (investment tax credits, research and development subsidies, subsidizing education, etc.) These programs have been shown as being effective ways to promote economic growth within an economy.

44. Rising Inequality

45. Trends in US Top Income Shares Over Time Note: Figure from the “World Inequality Report 2018”

46. Trends in US Top Real Pre-Tax Incomes Over Time Note: Figure from the “World Inequality Report 2018”

47. Trends in US Top Real Post-Tax Share Over Time Note: Figure from the “World Inequality Report 2018”

48. Trends in US Bottom Real Post-Tax Income Over Time Note: Figure from the “World Inequality Report 2018”

49. Trends in European Top Income Shares Over Time Note: Figure from the “World Inequality Report 2018”

50. Inequality Overview • Recent empirical work showing inequality is increasing: o Income inequality (Kevin Murphy, Larry Katz, Emmanuel Saez, Thomas Piketty, Ed Glaeser). o Consumption Inequality (Steve Davis , Me) o Employment Inequality (Kevin Murphy, Bob Topel, Me) o Wealth Inequality (Thomas Piketty, Emmanuel Saez) • What are the causes of increased inequality? • Is increased inequality detrimental to a society?