Aggregate Demand Policy in Perspective Problems with Fiscal Policy

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Supply Side versus Demand Side Policies The interrelationship between AS and AD is captured in the circular flow diagram. AS (production by firms) creates output and income, and hence AD (the potential demand to buy that output.

Supply Side versus Demand Side Policies The AS/AD model separates long-run aggregate supply from short-run aggregate demand forces. Demand-side policies (monetary and fiscal policy) shift the AD curve. Supply-side policies work by increasing potential output.

Supply Side versus Demand Side Policies Politicians are not constrained by models. They can, and do, often emphasize different interconnections.

Demand-Side and Supply-Side Policies Real output Price Level LAS Supply-side policies shift the LAS curve. SAS AD Demand-side policies (monetary and fiscal policies) shift the AD curve YP

Problems with Fiscal Policy Six assumptions of the AS/AD model lead to problems with fiscal policy: Financing the deficit has no offsetting effects. The government knows what the situation is. The government knows potential income. The government has flexibility in changing spending and taxes. The size of the government debt doesn’t matter. Fiscal policy doesn’t negatively affect other goals.

Financing the Deficit Doesn’t Have Offsetting Effects Some economists believe that government financing of deficit spending offsets the deficit’s expansionary effect. They believe that government borrowing increases interest rates and crowds out private investment.

Financing the Deficit Doesn’t Have Offsetting Effects Crowding out – the offsetting of a change in government expenditures by a change in private expenditures in the opposite direction.

Financing the Deficit Doesn’t Have Offsetting Effects Some economists argue that the effect of government expenditures is negative. They consider private spending to be more productive than government spending.

Financing the Deficit Doesn’t Have Offsetting Effects Crowding out also works in reverse in contractionary fiscal policy. When the government runs a surplus, it buys back bonds. Interest rates will drop, stimulating investment.

Partial Crowding Out Real output Price Level AD2 AD1 AD0 SAS Net effect Partial crowding out Y0 Y2 Y1

Knowing What the Situation Is Data problems limit the use of fiscal policy for fine tuning. Getting reliable numbers on the economy takes time. We may be in the middle of a recession and not know it.

Knowing What the Situation Is The government has large econometric models and leading indicators to predict where the economy will be in the near future. Economic forecasting is still very much an art and not a science.

Knowing the Level of Potential Income No one knows for sure the level of potential income. Potential income has been called the full-employment level of income.

Knowing the Level of Potential Income Differences in estimates of potential income often lead to different policy recommendations.

Knowing the Level of Potential Income In most cases, the U.S. economy is in an ambiguous state. Some economists will call for expansionary policy and others call for contractionary policy.

The Government’s Flexibility in Changing Taxes and Spending Putting fiscal policy into place takes time and has serious implementation problems. Numerous political and institutional realities in the U.S. today make it a difficult task to implement fiscal policy.

The Government’s Flexibility in Changing Taxes and Spending Squabbles between Congress and the President may delay implementing appropriate fiscal policy for months, even years.

Size of the Government Debt Doesn’t Matter These is no inherent reason why the adoption of activists policies should have caused high government deficits year after year.

Size of the Government Debt Doesn’t Matter Activist policy has led to an increase in government debt because: Early activists favored large increases in government spending as well as favoring the government's using fiscal policy. Politically, it is much easier for government to increase spending and decrease taxes than vice versa.

Size of the Government Debt Doesn’t Matter If one believes that debt is harmful, then there might be a reason not to conduct expansionary fiscal policy, even when the model calls for it.

Fiscal Policy Doesn’t Negatively Affect Other Government Goals An economy has many goals – achieving potential income is only one of those goals National economic goals often conflict.

Summary of the Problems While the six problems listed above do not necessarily eliminate fiscal policy altogether, they severely restrict it. Fiscal policy is a sledgehammer, not an instrument for fine-tuning.