Macro Chapter 12 Fiscal Policy, Incentives, and Secondary Effects

4 Learning Goals 1) 1)Explain the crowding-out effect 2) 2)Identify political incentives associated with fiscal policy 3) 3)Investigate the effect fiscal policy has on aggregate supply 4) 4)Summarize both sides of the debate about the effectiveness of fiscal stimulus

Transmitter question next

Survey Question: Which way of thinking most closely resembles your view? 1.Government intervention is necessary and helpful to direct economic outcomes. 2.Market forces work better than government intervention and that intervention is likely to do more harm than good.

Fiscal Policy, Borrowing, and the Crowding-Out Effect

Basic components of Crowding- Out: Class Activity: Draw the loanable funds market graph. Increase the demand for loanable funds. What happens to the interest rate? Class Activity: Draw the foreign exchange market graph. Which curve shifts when foreigners want more dollars? Does the dollar appreciate or depreciate?

Basic components of Crowding-Out: Y = C + I + G + X If the government (public sector) spends more, G rises Then businesses, consumers, and foreigners (private sector) spend less; C, I, and X fall Net effect is zero or a small positive increase in Y

First Secondary Effect: When the gov’t spends more, it either needs to borrow more or raise taxes to fund that spending If the gov’t borrows more, the demand for loanable funds increases which increases interest rates When interest rates increase, consumers buy less and businesses invest less If the gov’t raises taxes, consumers and businesses have less income which causes C and I to fall

Second Secondary Effect: If the gov’t borrows more, the demand for loanable funds increases which increases interest rates Higher interest rates will attract foreign investment which will cause the dollar to appreciate (because the demand for the dollar will increase) When the dollar appreciates, US exports fall and imports rise (net exports fall)

Two Transmitter questions next

Q12.1 The crowding-out model implies that a 1.budget surplus will be highly effective against inflation. 2.budget deficit is likely to stimulate aggregate demand and cause inflation. 3.budget deficit will increase real interest rates and, thereby, reduce private spending. 4.budget surplus will reduce aggregate demand and throw the economy into a downward spiral.

Q12.2 The crowding-out model implies that restrictive fiscal policy will 1.increase aggregate demand and employment. 2.lead to a significant increase in the natural rate of unemployment. 3.be highly effective against inflation. 4.reduce real interest rates.

Fiscal Policy, Future Taxes, and the New Classical Model

Skim on your own You are not expected to know details

Political Incentives and the Effective Use of Discretionary Fiscal Policy

Combine with next section

Is Discretionary Fiscal Policy an Effective Stabilization Tool?

Luigi Zingales: The main difference between Keynes and modern economics is the focus on incentives. Keynes studied the relation between macroeconomic aggregates, without any consideration for the underlying incentives that lead to the formation of these aggregates. By contrast, modern economists base all their analysis on incentives.

John M. Keynes The General Theory It is my belief that much unnecessary perplexity can be avoided if we limit ourselves strictly to the two units, money and labour, when we are dealing with the behaviour of the economic system as a whole; reserving the use of units of particular outputs and equipments to the occasions when we are analysing the output of individual firms or industries in isolation.

Summary: Fiscal policy is believed to be less effective than when Keynes first prescribed it

The Supply-Side Effects of Fiscal Policy

What are other effects of fiscal policy? Class Activity: Economics is Everywhere 19.1

In the Beatles’ song, the “Tax Man” sings, “There’s one for you, nineteen for me.” The Beatles are complaining about the high marginal tax rate that they faced in the United Kingdom in the 1960s. Implicitly, each extra pound that they earned left them only one shilling (one-twentieth of a pound in the old British money), with the remaining nineteen shillings going to the tax collector. This is clearly about the marginal tax rate, the tax on each extra bit of earnings, not the average tax rate, the ratio of taxes to total income. No tax system has an average tax rate of 95 percent on the entire tax base. The 95 percent marginal rate is also probably an exaggeration: Most systems have loopholes that allow some income to escape taxation when the rate is this steep. That Sir Paul McCartney is now a billionaire is pretty good evidence that the Beatles never really paid 95 percent of their earnings in taxes.

Class Activity : Make up an annual income for yourself. What is your marginal tax rate? How does that differ from your average tax rate?

Historical highest marginal tax ratesHistorical highest marginal tax rates: Historical highest marginal tax rates Historical tax rates: Historical tax rates:

A tax story Optional credit: Kamerschen tax story.pdf Read the article, write a one-half to one page summary on how you would divide the $20 refund, and why you would divide it that way. Upload your document to Blackboard by ___.

Some other details of tax payments Video:

See Mankiw- “I can afford higher taxes” article in Blackboard (not for optional credit, just FYI) Mankiw- “I can afford higher taxes”Mankiw- “I can afford higher taxes”

Transmitter Question Next

Q12.6 If the government cuts the tax rate, workers get to keep 1.less of each additional dollar they earn, so work effort increases, and aggregate supply shifts right. 2.less of each additional dollar they earn, so work effort decreases, and aggregate supply shifts left. 3.more of each additional dollar they earn, so work effort increases, and aggregate supply shifts right. 4.more of each additional dollar they earn, so work effort decreases, and aggregate supply shifts left.

Fiscal Policy and Recovery from Recessions

Will fiscal stimulus speed recovery from a recession? Argument for Yes: Only some crowding-out will occur so output will increase The multiplier is large so an increase in G will have a big effect Interest rates are weak incentives

Will fiscal stimulus speed recovery from a recession? Argument for No: More government spending now will lead to higher interest rates and taxes later Stimulus spending will increase structural unemployment Politically driven spending is inefficient Let’s see, recovery.gov recovery.gov

Are tax cuts a better tool than government spending? Argument for Yes: Tax cuts work faster Tax cuts are more efficient-you spend your money better than someone else spending it for you Tax cuts are easier to reverse Tax cuts increase the incentive to invest and produce

Are tax cuts a better tool than government spending? Argument for No: People will save their money rather than spend it Government spending can be directed to certain areas; tax savings will go different places Government doesn’t want to give up that revenue

Two Transmitter questions next

Q 12.4 Historically, Keynesian economists have argued that government spending will stimulate aggregate demand more than tax cuts because 1.government spending will stimulate aggregate demand more quickly than a tax cut. 2.there are fewer adverse side effects to an increase in government spending. 3.all of the spending will add to aggregate demand, but a portion of the tax cut will be saved. 4.an increase in government spending can quickly be reversed once the economy has recovered. 60

Q12.5 According to non-Keynesians, how will an increase in government spending financed by borrowing during a recession affect recovery? 1.Higher future taxes and interest rates will be required to finance the larger debt and this will weaken the recovery. 2.Repayment of the debt can always be shifted to the future, making it possible to keep tax rates low and thereby strengthen the recovery. 3.Higher interest payments will increase future government spending, and thereby promote a stronger the recovery. 4.The increase in government spending will exert a multiplier effect on the economy, leading to a stronger recovery. 60

U.S. Fiscal Policy:

You are seeing the debate unfold before you On January 1, 2009, the national debt was $10.7 trillion. Today, the national debt is over $17 trillion For numbers overload, visit usdebtclock.org usdebtclock.org

Who does the U.S. owe? See Special Topic 8 The Federal Budget and the National Debt for details The debt is divided into 2 categories: privately held (about 60%) and public (about 40%) Of the privately held debt, about one-half is owned by foreigners

"The fact that we are here today to debate raising America 's debt limit is a sign of leadership failure. It is a sign that the US Government cannot pay its own bills. It is a sign that we now depend on ongoing financial assistance from foreign countries to finance our Government's reckless fiscal policies. Increasing America 's debt weakens us domestically and internationally. Leadership means that, "the buck stops here.' Instead, Washington is shifting the burden of bad choices today onto the backs of our children and grandchildren. America has a debt problem and a failure of leadership. Americans deserve better." March, 2006 Senator Barack Obama

If you’re more interested: Fiscal stimulus package-Feb 2008 How federal spending has climbed since 2001 US government finance graphs WSJ-Short primer on the national debt

Video:

How Much is a Trillion? Inquiring minds want to know

What does one TRILLION dollars look like? All this talk about “stimulus packages” and “bailouts”... A billion dollars... A hundred billion dollars... Eight hundred billion dollars... One TRILLION dollars... What does that look like?

Here’s a hundred bucks We’ll start with a $100 dollar bill. Currently the largest U.S. denomination in general circulation. Most everyone has seen them, slightly fewer have owned them. Guaranteed to make friends wherever they go.

Serious coin A packet of one hundred $100 bills is less than 1/2" thick and contains $10,000. Fits in your pocket easily and is more than enough for a week or two of shamefully decadent fun.

One Million Dollars!!! Believe it or not, this next little pile is $1 million dollars (100 packets of $10,000). You could stuff that into a grocery bag and walk around with it.

That’s what I’m talkin’ about! While a measly $1 million looked a little unimpressive, $100 million is a little more respectable. It fits neatly on a standard pallet...

Holy cow! And $1 BILLION dollars... now we’re really getting somewhere...

Please have a seat Next we’ll look at ONE TRILLION dollars. This is that number we’ve been hearing so much about. What is a trillion dollars? Well, it’s a million million. It’s a thousand billion. It’s a one followed by 12 zeros. You ready for this?

And notice those pallets are double stacked $100 dollar bills! So the next time you hear your Congressman toss around the phrase “trillion dollars”... that’s what they’re talking about. $1 Trillion dollars:

Transmitter question next

Survey Question: Which way of thinking most closely resembles your view of fiscal policy? 1.I mostly agree with Keynes. Market forces either don’t work as well as predicted or work too slowly to return the economy to full employment. Government intervention is necessary. 2.I mostly agree with New Classical Economists and Hayek. Market forces work better than government intervention and that intervention is likely to create secondary effects which will inhibit growth.

Thomas Jefferson: “A government big enough to give you everything you want is strong enough to take everything you have.”

4 Learning Goals 1) 1)Explain the crowding-out effect 2) 2)Identify political incentives associated with fiscal policy 3) 3)Summarize both sides of the debate about the effectiveness of fiscal stimulus 4) 4)Investigate the effect fiscal policy has on aggregate supply