Principles of Macroeconomics Fiscal Policy and Debt

Learning Objectives Fiscal Policy and Debt Understand The concept of fiscal policy How to model the effect of fiscal policy on employment and inflation The concept of anticyclical policy The concept of crowding out

Unemployment and Expansionary Fiscal Policy Fiscal Policy and Debt Unemployment and Expansionary Fiscal Policy

Exercise: Fiscal Policy and Debt Assume a Keynesian SRAS (horizontal SRAS), show using a graph the effect of an expansionary fiscal policy. How do the results differ in terms of the effect on the price level? Brain-Twister: Under which assumption – holding everything else constant - is the fiscal expenditure multiplier greater – The Keynesian horizontal SRAS or the normal “upward sloped” SRAS? Derive the answer using a graph.

Fiscal Policy and Debt Again, just to remember, what crucial assumption paves the way for Keynesian economics? Answer: Unemployment does not lead to lower wages! In other words: The classical assumption of markets clearing due to price adjustments does not work. Wages are sticky.

Debt Fiscal Policy and Debt If economies abided by the principal of anticyclical fiscal policy, they should have, over time and on average, balanced budgets: Save in good times and spend it during bad times. But economies typically build up more and more debt – Is that a problem?

US Budget Deficits (2009 constant USD) Fiscal Policy and Debt US Budget Deficits (2009 constant USD)

Fiscal Policy and Debt US Public Debt

Is debt sustainable? Fiscal Policy and Debt Yes, as long as the funds borrowed from the public to finance public expenditures and interest grow at the same rate as the tax revenues. What matters is not absolute debt, but debt relative to GDP.

Problem Set: The concept of crowding out Fiscal Policy and Debt Problem Set: The concept of crowding out Crowding out: When expansionary fiscal policy drives out private investment