fiscal policy - university of wisconsin–madisonctaber/100/fiscalpolicy.pdf · fiscal policy •...

FISCAL POLICYC H A P T E R 9

Tuesday, November 22, 11

FISCAL POLICY

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FISCAL POLICY

• Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy

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FISCAL POLICY

• Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy• Discretionary Fiscal Policy: government

spending and tax changes enacted at the time of the problem to alter the economy

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FISCAL POLICY

• Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy• Discretionary Fiscal Policy: government

spending and tax changes enacted at the time of the problem to alter the economy• Nondiscretionary Fiscal Policy: that set of

policies that are built into the system to stabilize the economy (sometimes called automatic stabilizers)

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SMOOTHING GDP

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SMOOTHING GDP

• People would prefer to have smoother consumption than lumpier (obviously would rather have 3 meals every day then 6 meals per day in November and no food in December)

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SMOOTHING GDP

• People would prefer to have smoother consumption than lumpier (obviously would rather have 3 meals every day then 6 meals per day in November and no food in December)• For that reasons we don’t like recessions very much-even

if temporary they hurt at the time

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SMOOTHING GDP

• People would prefer to have smoother consumption than lumpier (obviously would rather have 3 meals every day then 6 meals per day in November and no food in December)• For that reasons we don’t like recessions very much-even

if temporary they hurt at the time• Fiscal policy is one way of smoothing things-we try to

provide some insurance during recessions so that things are better during a recession (and then presumably a bit worse during booms)

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HOW NONDISCRETIONARY FISCAL POLICY WORKS

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• Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically.

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• Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically.• Unemployment insurance, the progressive income tax,

and welfare serve as the built-in policies.• If the economy is in recession, those who lose their jobs

are granted unemployment and/or welfare benefits and they owe less in taxes.• If the economy is growing at an unsustainable rate,

people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits.

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HOW DISCRETIONARY FISCAL POLICY WORKS

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• If we are in a recession the fiscal policy to stimulate the economy would consist of• Government buying Stuff• Government paying people to do stuff• Decrease in taxes• Giving money directly to people

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• If we are in a recession the fiscal policy to stimulate the economy would consist of• Government buying Stuff• Government paying people to do stuff• Decrease in taxes• Giving money directly to people

• If we are in an inflationary period the fiscal policy to contract the economy would consist of just the opposite (I will focus on the first one since it is more relevant)

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EXPANSIONARY FISCAL POLICY I

6Real GDP

PriceIndex


SHOCKS

•A Shock is any unanticipated economic event.– Aggregate Demand Shock: an unexpected

event which causes aggregate demand to increase or decrease, e.g. the Sept 11, 2001 terrorist attacks.– Aggregate Supply Shock: an unexpected

event which causes aggregate supply to increase or decrease, e.g. Iraq’s 1990 invasion of Kuwait and threat to Saudi Arabia.

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EXPANSIONARY FISCAL POLICY IN RESPONSE TO A DEMAND SHOCK

8Real GDP

PriceIndex



8Real GDP

PriceIndex

We start out here



8Real GDP

PriceIndex

Then get hit by an aggregate demand shock



8Real GDP

PriceIndex

The Nondiscretionary fiscal policy undoes someof it



8Real GDP

PriceIndex

The Discretionarypolicy takes it upfurther


EXPANSIONARY FISCAL POLICY IN RESPONSE TO A SUPPLY SHOCK

9Real GDP

PriceIndex



9Real GDP

PriceIndex

We start out here



9Real GDP

PriceIndex

Then get hit by an aggregate supply shock



9Real GDP

PriceIndex

The Nondiscretionary fiscal policy undoes someof it



9Real GDP

PriceIndex

The Discretionarypolicy takes it upfurther


THE MULTIPLIER

• This isn’t in the book, but is a very important issue when thinking about fiscal policy• If I get $100 richer, I take my family out to a $100 dinner and leave

nice $20 tip• The server takes her $20 tip and uses it to buy a $12 umbrella• The umbrella store guy buys a burrito• etc.

• The bottom line is a $100,000,000 stimulus might boost GDP by more than $100,000,000• This is the main argument for a stimulus or a job creation

package• It depends on the marginal propensity to consume• There are major fights about this in the popular press

between various economists about this 10


LIMITATIONS

• More than anything: there is no free lunch. If you lower taxes or spend money today you need to raise taxes tomorrow. • Even if there is a large positive effect today there should

be a large negative effect tomorrow• Plus there is deadweight loss of taxation so overall effects

might be negative

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RICARDIAN EQUIVALENCE

• Some people argue it should be zero (Ricardian Equivalence)• Suppose interest rate is 10% and you give me $1000 today but will

raise my taxes by $1100 tomorrow. • It shouldn’t have any actual effect on my spending, I am not any

richer• I should just undo it by saving that money to pay my taxes

tomorrow• However, most economist don’t believe this works perfectly• People are not completely aware of what is going on• Some of it will be distribution from some people to others• Even more, could be redistribution from future generations to current

generations

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FURTHER ISSUES

•Even if this doesn’t happen perfectly, there is reason to believe that it might partly happen

•Further interest rates will automatically do some of this•Government borrows•This causes interest rate to go up•People choose to save more

•Hiring workers might also lead to multiplier less than 1•Government hires someone to build a highway•That person might have gotten a job doing something else•In this case you didn’t necessarily “create a job” for every worker you hire


EVALUATING NONDISCRETIONARY FISCAL POLICY

• Most economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions.

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THE MISTIMING OF DISCRETIONARY FISCAL POLICY

• Recognition Lag: the time it takes to measure the state of the economy• Administrative Lag: the time it takes for

Congress to agree on a course of action with the president• Operational Lag: the time it takes for the

full impact of a government program or tax change to have its effect on the economy

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POLITICAL PROBLEMS WITH FISCAL POLICY

• Expansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts.• The Political Business Cycle suggests that

politically motivated fiscal policy is used for short term gain just prior to elections

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THE RISE, FALL AND REBIRTH OF DISCRETIONARY FISCAL POLICY

• Between 1975 and 2001 fiscal policy was pretty much abandoned as a mechanism for controlling the economy.•Monetary policy was used to expand or

contract prices and GDP.• In 2001, the impending recession

motivated tax rebates and the Sept. 11 attacks motivated a variety of tax cut and spending increase ideas in Congress.• In 2003, the continuing slow growth

motivated a renewal of the tax credit 17


THE 2003 REBATE

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OBAMA STIMULUS PLAN

S"mulus Plan Element Amount in Millions

Non-‐Discre+onary Fiscal Policy: Unemployment, Welfare, Medicaid $135,832

Aid to States $53,600

Discre+onary Fiscal Policy: Tax Cuts $301,135

Discre+onary Fiscal Policy: Spending Increases $300,047


CURRENT JOBS PACKAGE PROPOSED BY PRESIDENT OBAMA

• Total amount is around $450 billion• Payroll tax cut for businesses and workers• Tax breaks to businesses that hire• Tax credit to hire long-term unemployed• Extend unemployment insurance• Tax credit for veterans• Help refinance mortgages • Tax changes to pay for it(mostly raising taxes on rich)• Money for schools• Infrastructure projects• Prevent teacher, police and firefighter layoffs

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fiscal policy - university of wisconsin–madisonctaber/100/fiscalpolicy.pdf · fiscal policy •...

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