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Final Lecture: Fiscal Policy

Final Lecture: Fiscal Policy. C.L. Mattoli. This week. Final Topic: Fiscal Policy Chapter 17, texbook. Learning objectives. Explain the nature and operation of both ‘discretionary’ and ‘supply-side’ fiscal policy

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Final Lecture: Fiscal Policy

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  1. Final Lecture:Fiscal Policy C.L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008

  2. This week • Final Topic: Fiscal Policy • Chapter 17, texbook (C) Red Hill Capital Corp., Delaware, USA 2008

  3. Learning objectives • Explain the nature and operation of both ‘discretionary’ and ‘supply-side’ fiscal policy • Explain the concepts of the ‘balanced budget multiplier’ and ‘automatic stabilizers’ • Discuss the importance of a government’s budget for macroeconomic performance. (C) Red Hill Capital Corp., Delaware, USA 2008

  4. Previously • We started the course talking about an economy’s PPF, the maximum efficient set of economic output that an economy can have. • Then, we looked at markets and discovered how psychology goes into making up the supply and demand schedules for any individual good or service (G&S). • Next, we saw how people are self-interested but economy thinks of them as enlightened self-interested. (C) Red Hill Capital Corp., Delaware, USA 2008

  5. Previously • We discovered, though, that self-interest, like profit making or money keeping, can lead to market imperfections. • One, self-interest in profits can lead to pollution for everyone. Self-interest in wanting a free ride can mean that suppliers are not getting paid what they are truly due. • Thus, the government found its first place for intervention. The answers are taxes/subsidies or regulation. (C) Red Hill Capital Corp., Delaware, USA 2008

  6. Previously • The government also taxes things that it thinks are bad, like alcohol, cigarettes, and gasoline. • We, then, looked at the overall economy, again, and defined broad variables, culminating on looking at AD-AS in the aggregate economic macro market. • The government is involved in the macro picture, from the start, because it actually prints the money that is used for the transactions in the economy and controls the banking system who manage and create some of the money (so, it needs monetary policy). (C) Red Hill Capital Corp., Delaware, USA 2008

  7. Previously • Then, since the government is involved in the money supply, it is necessary that it have monetary policy for managing the supply and the growth of supply of the money because those variables will interact with prices for money and also for goods and services: interest rates and inflation. • Moreover, since money is needed to transact business, the amount of money in the economic system can affect the final outcome of activity, real GDP. (C) Red Hill Capital Corp., Delaware, USA 2008

  8. Previously • The government also found another “in” to involvement in the economy, in Keynesian economics: that is the fiscal policy, the government spending and taxation, means by which a government can become involved in helping the economy, a notion that was thought to be unnecessary in classical economics. • In this last lecture, we take a closer look at the fiscal policy affects on the economy. (C) Red Hill Capital Corp., Delaware, USA 2008

  9. Intro • Governments have a role in the economy. • They have to provide public goods and services that free riders would not pay for otherwise. • There are things, like protection from enemies of all sorts from outside the country and within, right down to the person that you buy your food and housing from: you wouldn’t want them to cheat you or take advantage of you. It might even have health and retirement plans for its citizens. (C) Red Hill Capital Corp., Delaware, USA 2008

  10. Intro • This gives government an initial raison d’etre (reason for being), and the next step is to collect revenues, in the form of taxes, to support its spending. • Its spending is also part of the economy. • It pays people to act as protectors, like policemen, soldiers, and consumer and financial advocates and watchdogs. (C) Red Hill Capital Corp., Delaware, USA 2008

  11. Intro • It buys goods and services to build highways and other country infrastructures. • Thus, the government can spend money in such a way as to have an affect on the economy. It can also affect it with taxes. • Then, that affect can be magnified (multiplier effect) because those people getting money to do things for the government spend their money on other things in the economy, and from an acorn springs an oak. (C) Red Hill Capital Corp., Delaware, USA 2008

  12. Discretionary Fiscal Policy (C) Red Hill Capital Corp., Delaware, USA 2008

  13. Discretionary Fiscal Policy • Previously, we discussed Keynes theory that the economy sometimes needs to be kick-started through the initiation of government spending to stimulate economic activity and psychological attitudes of business and consumers. That was the birth of so-called discretionary fiscal policy. (C) Red Hill Capital Corp., Delaware, USA 2008

  14. Discretionary Fiscal Policy • Today, discretionary fiscal policy is meant to describe the deliberate use of government spending and taxation to alter aggregate demand to stabilize an economy in some sort of desirable way. • In the next slide, we show the 2 directions fiscal policy can turn: expansionary or contractionary. (C) Red Hill Capital Corp., Delaware, USA 2008

  15. Routes in 2 directions of discretion (C) Red Hill Capital Corp., Delaware, USA 2008

  16. Graphical Economy: AD-AS • Assume graphical AD-AS curves for the analysis • Simplistically, we use straight lines. • Full employment is at real GDP $520 billion. Causal Chain Price level AD2 AS Increase In G E2 155 E1 X 150 Increase In AD curve Full Employment AD1 Increase in Price level & Real GDP Real GDP ($ bil.) $500 $520 $540 (C) Red Hill Capital Corp., Delaware, USA 2008

  17. Increase spending to fight recession • Assume the economy has entered recession and is at E1, in the AD-AS graph shown in the slide, at real GDP = $500 billion, below the full employment level, and price level =150 on the CPI. • Even though the economy is operating above the horizontal AS Keynesian range, the government can still act to stimulate the economy, trying to push it to full employment, although with higher prices, shifting AD1 to AD2. (C) Red Hill Capital Corp., Delaware, USA 2008

  18. Increase spending to fight recession • Recall that a shift in private demand, from C, I, or (X – M), could also do the job, but these are not within the government control. However, G is. • There is always a long list of government spending proposals for roadways, health car, environmental, education, etc. Thus, there is government demand just waiting to happen. • Given that fact, the government can initiate spending to increase employment, in the short-run. (C) Red Hill Capital Corp., Delaware, USA 2008

  19. Increase spending to fight recession • The question becomes, just how much spending does the government have to do? • Whatever spending in G, it will seep through the economy and affect C and, perhaps, I. The money to those, directly from increased G, will be partly spent, which will be income for a new group of people, which will get partly spent, again, an so on. That is the spending multiplier effect. (C) Red Hill Capital Corp., Delaware, USA 2008

  20. Increase spending to fight recession • The spending multiplier will depend on the MPC of the recipients. We shall take a closer look at how that works. • Suppose for example, that the initial spending was $10 billion and that MPC of recipients is 0.75: 75% of new income is spent on consumption. The eventual result after all of the rounds of re-spending will be that AD is pushed out by $40 billion to X. Lets look at the process in more detail. (C) Red Hill Capital Corp., Delaware, USA 2008

  21. Increase spending to fight recession • First, $10 bil. gets spent in G, then 0.75x$10 bil. gets spent in the next round, 0.75x0.75x$10 bil. gets spent in the next, and so on and so on. • We can summarize this as Total spending approaches G + MPC G + MPC2 G + MPC3G + … = G Multiplier = n=0∞ MPCnG, the sum of powers of MPC from 0 to infinity times G. (C) Red Hill Capital Corp., Delaware, USA 2008

  22. Increase spending to fight recession • The equation, even though it is an infinite sum, it actually has a simple solution: Total Spending = G x 1/(1 – MPC) = G/MPS. • Thus, the multiplier is equal to 1/MPS, in this case, 1/0.25 = 4, so Total spending = G x 4 = $40 billion. Pushing the AD curve out to the new one, AD2. (C) Red Hill Capital Corp., Delaware, USA 2008

  23. Increase spending to fight recession • The new AD curve, then, intersects the old AS at a new equilibrium point, E2. • The result is that full employment is achieved and real GDP rises, but the increased demand of $40 billion does not translate into that much of a rise of real GDP: (C) Red Hill Capital Corp., Delaware, USA 2008

  24. Increase spending to fight recession • GDP rises by only $20 billion but demand pull inflation increased the price level from 150 to 155, a rise of about 3%. • Thus, we conclude that in the neo-classical region of AS, increased government spending does not result in the theoretical maximum rise in output, G/MPS. It is less and there is also inflation. (C) Red Hill Capital Corp., Delaware, USA 2008

  25. Tax cut to battle recession • Another fiscal policy tool to combat recession is cutting taxes. • Suppose that the government enacts a $10 billion personal tax cut. Thus, instead of increasing spending by $10 billion, like in the first example, the government decreases it revenues by the same $10 billion. • The result is an increase of $10 billion in personal disposable income, DI. (C) Red Hill Capital Corp., Delaware, USA 2008

  26. Tax cut to battle recession • That results in a first round of spending of MPCDI = 0.75$10 billion = $7.5 billion, still assuming that MPC=0.75. Then, that money gets multiplied trough spending rounds. • It is important to note, then, that a tax results in a smaller stimulus to overall AD than the same sized increase in government spending. (C) Red Hill Capital Corp., Delaware, USA 2008

  27. Tax cut to battle recession • We can use the same equation as in the previous example to get an equation for the theoretical maximum increase in AD as increase in AD = MPC  Tax cut/MPS = $30 billion, since MPC  Tax is the 1st round. • We point out that an increase in welfare payments, for example, would also result in stimulus similar to that of a tax cut. However, we also point out that welfare recipients are lower income people, so they would probably have higher than average MPC’s. (C) Red Hill Capital Corp., Delaware, USA 2008

  28. Fiscal policy to fight inflation • If expansionary fiscal policy can fight recession, then, perhaps contractionary fiscal policy can fight inflation, particularly, demand pull inflation. • Now, we assume that the economy is in the classical range of AS, as shown in the figure in a subsequent slide, operating at full-employment real output of $520 billion at a price index level of 160. • In that situation, any increase in AD will result only in higher prices, no change in output. (C) Red Hill Capital Corp., Delaware, USA 2008

  29. Fiscal policy to fight inflation • Thus, suppose that the government uses fiscal policy to try to reduce the price level because it wants to reduce inflation in the economy. • One way to go about that would be to reduce government spending. If the government cuts spending by $5 billion, the multiplier effect will result in decreased overall AD of $5 billion/MPS = $20 billion. (C) Red Hill Capital Corp., Delaware, USA 2008

  30. Fiscal policy to fight inflation • Then, as shown in the figure, the AD curve shifts left by a horizontal distance of $20 billion. • There will be a temporary excess supply by $20 billion resulting in pressure on firms to reduce prices, and a new intersection equilibrium will be established at E2, with the same output but a decrease in the price level from 160 to 155. (C) Red Hill Capital Corp., Delaware, USA 2008

  31. Fiscal policy to fight inflation • We must point out that, while in theory the price level would be reduced, that would rarely happen in reality. • The actual outcome would likely manifest as a reduction in the rate of inflation, rather than an actual drop in prices. • The important thing is that by using either tightened monetary policy or contractionary fiscal policy, the government can try to reduce inflation in an economy. (C) Red Hill Capital Corp., Delaware, USA 2008

  32. Fiscal policy to fight inflation • Just like in the previous example of expansionary fiscal policy, an alternative to cutting G would be raising taxes, although that solution would be politically unpopular, but we can look at the mechanism, at least. • Therefore, suppose that the government wants to reduce AD by $20 billion by increasing taxes. We can take a lesson from our previous tax reduction example. (C) Red Hill Capital Corp., Delaware, USA 2008

  33. Fiscal policy to fight inflation • To raise AD by $20 billion, we learned that the government would have to decrease taxes by $6.67 billion (=MPCDI/MPS), so to decrease AD by $20 billion, it would have to increase taxes by the same $6.67 billion. • Although, theoretically, a government could use fiscal policy to try to combat inflation, these days, in practice, controlling inflation is done with monetary policy through the central bank. (C) Red Hill Capital Corp., Delaware, USA 2008

  34. Graphical Economy: AD-AS • Full employment is at real GDP $520 billion. • We begin up the vertical line with demand pull inflation already in place. Causal Chain Decrease in G Or Increase d taxes Price level AD1 AS E2 160 Decrease In AD curve E1 155 AD2 Full Employment Decrease in Price level Real GDP ($ bil.) $500 $520 $540 (C) Red Hill Capital Corp., Delaware, USA 2008

  35. Automatic Policy (C) Red Hill Capital Corp., Delaware, USA 2008

  36. Balanced budget multiplier • In our discussion of discretionary Keynesian fiscal policy, the government uses either spending or taxes to fight recession or inflation. • However, using one or the other, spending or taxes, will produce an imbalance in the government's budget, revenues versus spending. • An approach to fiscal policy that has gained support in the 1980’s and 1990’s is a balanced budget approach that matches any new spending with new taxes, so that there is a neutralizing affect on government financing. (C) Red Hill Capital Corp., Delaware, USA 2008

  37. Balanced budget multiplier • To understand the affect of this brand of policy, we must introduce the concept of the balance budget multiplier. • We examined changes both changes in taxes and spending and found that the separate spending multipliers depended on MPC. • We can even look at the effect in terms of the separate multipliers with G = – T = X. (C) Red Hill Capital Corp., Delaware, USA 2008

  38. Balanced budget multiplier • Then, AD = X/MPS – XMPC/MPS) = X(1 – MPC)/MPS = XMPS/MPS = X. • Thus, identically, the balanced budget multiplier = 1, no matter what MPC is. • Thus, a balanced budgetfiscal expansionary increase or decrease in spending will result in a equal change in AD, e.g., G = AD. (C) Red Hill Capital Corp., Delaware, USA 2008

  39. Automatic stabilizers • In contrast to discretionary fiscal policy, the automatic stabilizer approach is a programmed approach that automatically adjusts over the course of the business cycle to fight both inflation and unemployment. • In this approach, spending and taxes automatically change over the business cycle, in such a manner as to stabilize expansions and contractions in economic activity. (C) Red Hill Capital Corp., Delaware, USA 2008

  40. Automatic stabilizers • G = government spending, including transfer payments, like unemployment benefits and other social welfare payments. • It decreases as Real GDP rises. G is inversely related to real GDP. • That inverse relationship is meant to counteract some of the effects of changes in output. (C) Red Hill Capital Corp., Delaware, USA 2008

  41. Automatic stabilizers • When the economy contracts, there is more of a need for unemployment benefits and welfare and other spending to stimulate the economy, and vice versa. • On the tax side, as the economy expands, people and businesses make more money, and they, necessarily, will pay more taxes. T is direct. • We look at the situation, graphically, in the next slide. (C) Red Hill Capital Corp., Delaware, USA 2008

  42. Automatic stabilizers, graphically • The balanced budget (G=T) equilibrium GDP is $500 billion. • Then, look at changes in GDP. Balanced Budget $110 Budget Surplus Budget Deficit $100 G & T $ billion $90 $470 $500 $530 Real GDP $ billion (C) Red Hill Capital Corp., Delaware, USA 2008

  43. Automatic stabilizers: causal chains Budget Offsets Inflation Real GDP Increases Tax revenues rise & transfer payments fall Budget Offsets Recession Tax revenues fall & Transfer increase Real GDP Decreases (C) Red Hill Capital Corp., Delaware, USA 2008

  44. Example analysis • Suppose the equilibrium balanced budget real GDP starts out at $500 billion. • Next, imagine that increased consumer optimism has resulted in increased consumer spending, which ultimately results in a new level of real GDP at $530 billion. • As a result, government tax revenues increase to $110 billion due to greater business activity, while expenditures reduce to $90 billion. (C) Red Hill Capital Corp., Delaware, USA 2008

  45. Example analysis • Thus, the government has a budget surplus: revenues exceed expenditures and the government makes a profit. • Alternatively, assume that there is a recession and real GDP decreases to $470 billion. • Then, tax revenues will decrease to $90 billion, while expenditures will expand to $110 billion, as more people become unemployed, for example. • In this phase of the business cycle, government expenses will outstrip revenues, and the government operation will run a loss, a budget spending deficit. (C) Red Hill Capital Corp., Delaware, USA 2008

  46. Auto stabilizers: leaning into the wind • The beauty of automatic stabilizers is that there effect is counteractive (it leans against the prevailing wind). • When the economy heats up, the government pays out less, and it takes away more from people in the economy. • Thus, the effect of the stabilizers will be to moderate AD. (C) Red Hill Capital Corp., Delaware, USA 2008

  47. Auto stabilizers: leaning into the wind • When the economy goes into recession, tax revenues decrease and people get more transfer payments for unemployment and welfare. • Thus people get more money than they would have from the economic activity, and the downdraft in the economy is offset by this extra money. (C) Red Hill Capital Corp., Delaware, USA 2008

  48. Stabilizers: Some Further Notes • It is nice to know that multiplier effects will act to magnify changes in, for example, government spending or taxation. • However, the dependence on MPC and the assumption of infinite rounds of spending to get a compact equation in terms of MPC, means that our simple estimate will not be accurate. • Alternatives to measure multipliers would be to observe cause and effect, in the markets, but, again, there would be difficulty in isolating affects. (C) Red Hill Capital Corp., Delaware, USA 2008

  49. Stabilizers: Some Further Notes • Thus, in the end, multipliers are difficult and expensive to determine, and the result will still have quite a bit of uncertainty, anyway. • On the practical side, it has been argued that in a near-full-employment economy like Australia’s, government spending diverts resources from other sectors and generates costs (inflation and interest rate pressures), not benefits. • On the other hand, multipliers can be used to justify public investments to vested interests in areas such as arts, environmental improvements, sports and culture (because outcomes are often non-quantifiable). (C) Red Hill Capital Corp., Delaware, USA 2008

  50. Supply-side Fiscal Policy (C) Red Hill Capital Corp., Delaware, USA 2008

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