Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard Stroup, and Russell Sobel Fiscal Policy Chapter 12

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Budget Deficits and Surpluses

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Budget Deficits and Surpluses n Budget deficit: -- Present when total government spending exceeds total revenue from all sources. n When the money supply is constant, deficits must be covered with borrowing. n The U.S. Treasury borrows funds by issuing bonds. n Budget surplus: -- Present when total government spending exceeds total revenue from all sources. n Surpluses reduce the size of the governments outstanding debt.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Budget Deficits and Surpluses n Changes in the size of the federal deficit or surplus are often used to gauge whether fiscal policy is adding additional demand stimulus or imposing additional demand restraint. n Changes in the size of the budget deficit or surplus may arise from either: n A change in the state of the economy, or, n A change in discretionary fiscal policy -- that is, through either government spending and/or changes in taxation.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. The Keynesian View of Fiscal Policy

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Keynesian View of Fiscal Policy n Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in demand. n When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy -- it should either: n increase the governments purchases of goods & services, and/or, n cut taxes.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS AD 1 Y F P 1 Y 1 SRAS 1 Y F e1e1 P 3 n We begin in the short run at Y 1, below the economys potential capacity (Y F ). There are 2 routes to long-run full-employment equilibrium. n Policymakers could wait for both lower wages and resource prices to reduce costs, increase supply to SRAS 3 and restore equilibrium at Y F. P 2 Expansionary Fiscal Policy to Promote Full-Employment n Alternatively, expansionary fiscal policy could stimulate aggregate demand (shift AD 1 to AD 2 ) and guide the economy back to E 2, at Y F. SRAS 3 Expansionary fiscal policy stimulates demand and directs the economy to full-employment AD 2 Keynesians believe that allowing for the market to self-adjust may be a lengthy and painful process. E3E3 E2E2 Y F Y F

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Keynesian View of Fiscal Policy n When inflation is a potential problem, the Keynesian analysis suggests a shift toward a more restrictive fiscal policy: n reduce government spending, and/or, n raise taxes. n Keynesians challenged the view that the governments should always be balance its budget. n Rather than balancing the budget annually, Keynesians argued that counter-cyclical policy should be used to offset fluctuations in aggregate demand.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS Y F P 1 Y 1 SRAS 1 AD 1 e1e1 P 2 n Strong demand such as AD 1 will temporarily lead to an output rate beyond the economys long-run potential (Y F ). n If maintained, the high level of demand will lead to the long-run equilibrium E 3 at a higher price level (as SRAS shifts back to SRAS 3 ). P 3 Restrictive Fiscal Policy to Combat Inflation n However, restrictive fiscal policy could restrain demand from expanding to AD 2 in the first place and guide the economy to a non-inflationary equilibrium (E 2 ). SRAS 3 Y F Restrictive fiscal policy restrains demand and helps control inflation. AD 2 E3E3 E2E2 Y F

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. Fiscal Policy and the Crowding-out Effect

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Fiscal Policy and the Crowding-out Effect n The Crowding-out Effect: -- indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy. n The implications of the crowding-out analysis are symmetrical. n Restrictive fiscal policy will reduce real interest rates and "crowd in" private spending. n Crowding-out Effect in an open economy: -- Larger budget deficits and higher real interest rates also lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Increase In Budget Deficit Higher Real Interest Rates Inflow of Financial Capital from Abroad Decline in Private Investment Appreciation of the Dollar Decline in Net Exports A Visual Presentation of the Crowding-Out Effect in an Open Economy n An increase in govt. borrowing to finance an enlarged budget deficit places upward pressure on real interest rates. n This retards private investment and thereby Aggregate Demand. n As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates. n In turn, the appreciation of the dollar causes net exports to fall. n Thus, as a result of increased budget deficits, higher interest rates trigger reductions in both private investment and net exports, which weaken the expansionary impact of a budget deficit. n In an open economy, higher interest rates attract capital from abroad.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. The New Classical View of Fiscal Policy

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The New Classical View of Fiscal Policy u debt financing merely substitutes higher future taxes for lower current taxes, and thus, u budget deficits affect the timing of taxes, but not their magnitude. n The New classical view stresses that: n New Classics argue that when debt is substituted for taxes u people will save the increased income so they will be able to pay the higher future taxes, thus, u the budget deficit does not stimulate aggregate demand.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The New Classical View of Fiscal Policy n Similarly, the real interest rate is unaffected by deficits since people will save more in order to pay the higher future taxes. n According to the new classical view, fiscal policy is completely impotent. It does not effect output, employment, or real interest rates.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level P 1 Y 1 SRAS 1 AD 1 New Classical View -- Higher Expected Future Taxes Crowd-out Private Spending n New Classical economists emphasize that budget deficits merely substitute future taxes for current taxes. AD 2 n If households did not anticipate the higher future taxes, aggregate demand would increase (from AD 1 to AD 2 ). n However, demand remains unchanged at AD 1 when households fully anticipate the future increase in taxes and, so, save for them.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. L oanable F unds P rice level r 1 Q 1 D1D1 S1S1 e1e1 r 1 New Classical View -- Higher Expected Future Taxes Crowd-out Private Spending n According to the new classical view, people will save more in order to pay the higher future taxes implied by the increases in debt. This will increase the supply of loanable funds to S 2. D2D2 n This permits the government to borrow the funds to finance the deficit without pushing up the interest rate. S2S2 e2e2 n In order to finance the budget deficit, the govt borrows from the loanable funds market, increasing the demand (from D 1 to D 2 ). Q 2 Under this model, fiscal policy exerts no effect -- the interest rate, real GDP, and level of unemployment each remain unchanged.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 5. Fiscal Policy: -- Problems of Proper Timing

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Fiscal Policy: -- Problems with Proper Timing n Various time lags make proper timing of changes in discretionary fiscal policy difficult. n Discretionary fiscal policy is like a two-edged sword; it can both harm and help. u If timed correctly, it may reduce economic instability. u If timed incorrectly, however, it may increase economic instability.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS AD 0 P 0 Y F SRAS Y F E0E0 n We begin long-run equilibrium (E 0 ) at the price level P 0 and output Y 0. At this output, only the natural rate of unemployment is present. n An investment slump and business pessimism result in an unanticipated decline in AD (to AD 1 ). Output falls and unemployment increases. P 1 Y 1 Why Proper Timing of Fiscal Policy is Difficult n After a time, policymakers institute expansionary fiscal policy seeking to shift AD back to AD 0, but by the time fiscal policy begins to exert its primary effect, private investment has recovered and decision makers have become increasingly optimistic about the future. AD 1 Consider that shifts in AD are difficult to forecast. e1e1

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Thus, just as AD begins shifting back to AD 0 by its own means, the effects of fiscal policy over-shift AD to AD 2. n The price level in the economy rises as the economy is now overheated. Why Proper Timing of Fiscal Policy is Difficult n Unless the expansionary fiscal policy is reversed, wages and other resource prices will eventually increase, shifting SRAS back to SRAS 2 (driving the price level up to P 3 ). G oods & S ervices (real GDP) P rice level LRAS AD 0 P 0 Y F P 2 P 1 Y 1 SRAS Y F AD 2 e2e2 e1e1 AD 1 Y 2 P 3 SRAS 2 e4e4 AD 0 E0E0

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS P 0 Y F SRAS Y F AD 0 E0E0 n Alternatively, suppose an investment boom disrupts the initial equilibrium shifting aggregate demand out to AD 2, placing upward pressure on prices. n Policymakers respond by increasing taxes and cutting government expenditures, but by the time that the restrictive fiscal policy has had an opportunity to take effect, investment returns to its normal rate (shifting AD 2 back to AD 0 ). Why Proper Timing of Fiscal Policy is Difficult P 2 AD 2 e2e2 Y 2 E0E0

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n Thus, just as AD begins shifting back to AD 0 by its own means, the effects of fiscal policy over-shift AD to AD 1. n The price level in the economy falls as the economy is now thrown into recession. Why Proper Timing of Fiscal Policy is Difficult n Because fiscal policy does not work instantaneously, and since dynamic factors are constantly influencing private demand, proper timing of fiscal policy is not an easy task. G oods & S ervices (real GDP) P rice level LRAS AD 0 P 0 Y F P 2 P 1 Y 1 SRAS Y F AD 2 E0E0 e2e2 AD 1 Y 2 e1e1 AD 0 E0E0

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Fiscal Policy: -- Problems with Proper Timing n Automatic Stabilizers: -- without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom. n Examples of Automatic Stabilizers : u Unemployment Compensation u Corporate Profit Tax u A Progressive Income Tax

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 6. Fiscal Policy as a Tool: -- A Modern Synthesis

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Fiscal Policy as a Tool: -- A Modern Synthesis n The proper timing of discretionary fiscal policy is both difficult to achieve and of crucial importance. n Automatic stabilizers reduce the fluctuation of aggregate demand and help to direct the economy toward full-employment. n Fiscal policy is much less potent than the early Keynesian view implied.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. What is the Keynesian view of fiscal policy? How do the crowding-out and new classical models modify the basic Keynesian analysis? Questions for Thought: 2. Why is the proper timing of a change in fiscal policy important? 3. "Budget deficits may stimulate aggregate demand and output in the short run, but since they divert funds away from capital formation and toward current consumption, they will retard the growth of output in the long run." Do you agree with this statement?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 7. Supply-side Effects of Fiscal Policy

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Supply-side Effects of Fiscal Policy n From a supply-side viewpoint, the marginal tax rate is of crucial importance: n High marginal tax rates will tend to retard total output because they will: u A reduction in marginal tax rates increases the reward derived from added work, investment, saving, and other activities that become less heavily taxed. u Discourage work effort and reduce the productive efficiency of labor, u Adversely affect the rate of capital formation and the efficiency of its use, and, u Encourage individuals to substitute less desired tax-deductible goods for more desired non-deductible goods.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Supply-side Effects of Fiscal Policy n Thus, changes in marginal tax rates, particularly high marginal rates, may exert an impact on aggregate supply because the changes will influence the relative attractiveness of productive activity in comparison to leisure and tax avoidance. n Impact of supply-side effects u Are likely to take place over a lengthy time period. u There is some evidence that countries with high taxes grow more slowlyFrance and Germany versus United Kingdom. u While the significance of supply-side effects are controversial, there is evidence they are important for taxpayers facing extremely high rate, say rates of 40 percent and above.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. G oods & S ervices (real GDP) P rice level LRAS 1 P 0 Y F1 SRAS 1 AD 1 E1E1 P 0 n What are the supply-side effects of a reduction in marginal tax rates? n The lower marginal tax rates increase the incentive to earn and use resources efficiently. AD 1 shifts out to AD 2, and as the effects of the tax cut are long-run as well as short-run, both SRAS and LRAS shift out. Tax Rate Effects and Supply-Side Economics n If the lower tax rates are financed by budget deficits, aggregate demand may expand by a larger amount than aggregate supply, leading to an increase in the price level. Y F2 AD 2 SRAS 2 LRAS 2 With time, lower tax rates will promote more rapid growth (shifting LRAS and SRAS to the right to LRAS 2 and SRAS 2 ). E2E2

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved Y ear < S hare of P ersonal I ncome T axes P aid by T op 0.5 P ercent of E arners 1986 Top rate 50% to 30% cut from 1990–93 Top rate raised from 30% to 39.6% 1964–65 91% to 70% Top rate cut from % to 50% Top rate cut from How Have Changes in Marginal Tax Rates Affected the Share of Taxes Paid By The Rich? n The above graph indicates the share of the personal income tax paid by the top one-half percent of earners during There were 3 major reductions in the top marginal tax rate during this period. n Note that the share of the tax bill paid by these super-rich earners increased following each of the tax cuts and fell when inflation pushed more and more taxpayers into higher tax brackets during the 70s and when rates were raised again (to 39.6%) during the Bush/Clinton years. This graphic illustrates that, at least for this group of high-income recipients, there existed strong supply- side effects associated with changes in marginal rates.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 8. Empirical Evidence on the Impact of Fiscal Policy

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved Y ear < R evenues E xpenditures D eficits P ercent of Real GDP Empirical Evidence on the Impact of Fiscal Policy n Budget deficits and interest rates: n Fiscal policy during the past 4 decades: u Since 1960 the federal budget as a % of GDP has generally increased during recessions and declined during periods of economic expansion. u The year-to-year relationship is weak. u However, interest rates were high as the deficits of the early 80s rose.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. C omponent as a % of GDP 1976– – – –1994 Differential B F ederal D eficit % Of GDP T ime P eriod P ersonal C onsumption R eal I nterest R ate A G ross I nvestment L ess N et F oreign I nvestment N et F oreign I nvestment G ross P rivate I nvestment N et E xports A The real interest rate was derived by subtracting the annual inflation rate as measured by the GDP deflator from the AAA corporate bond rate. B Later period minus earlier period. As the data of the first column indicate, the federal deficits were larger during the later period. Source: Derived from the Economic Report of the President, 1996, Tables B-1, B-3, B-28, and B-73. D ifferential B n Appreciation of the dollar, capital inflow and net exports: n Consumption and Investment: u As deficits rose from 83 to 87, consumption rose (from 62.2% to 65%), consequently savings fell (also in period). u This runs contrary to the new classical view. u As deficits rose from 83 to 87, net foreign investment rose (from 0% to 2.6%), while net exports fell. (also in period). u This is consistent with the crowding-out model. Empirical Evidence on the Impact of Fiscal Policy

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 9. Current View of Fiscal Policy

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Current View of Fiscal Policy n Compared to two decades ago, there is now greater awareness of the political and economic factors that make the proper timing of fiscal policy difficult. n There is now more concern about the impact of budget deficits on interest rates and capital formation. n In the 1990s, there has been more emphasis on controlling the deficit and balancing the budget.

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. The following quotation was made in the mid-1980s by Paul Samuelson, perhaps the leading American Keynesian: In the early stages of the Keynesian revolution, macro- economists emphasized fiscal policy as the most powerful and balanced remedy for demand management. Gradually, shortcomings of fiscal policy became apparent. The short- comings stem from timing, politics, macroeconomic theory, and the deficit itself." What are the shortcomings Samuelson is referring to? Questions for Thought: 2. Outline the supply-side view of fiscal policy. How does this view differ from the various demand-side theories? 3. The budget deficit decreased steadily during What factors accounted for the reduction in the deficit during the period? Do you think a change in views toward fiscal policy played any role? Did the deficit reduction exert a positive or negative impact on the economy?

Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Chapter 12