1 Fiscal Policy Chapter 9

2 Fiscal Policy Fiscal Policy is the purposeful movement in government spending or tax policy designed to direct an economy Discretionary Fiscal Policy: government spending and tax changes enacted at the time of the problem to alter the economy Nondiscretionary Fiscal Policy: that set of policies that are built into the system to stabilize the economy (sometimes called automatic stabilizers) 2

3 Smoothing GDP People would prefer to have smoother consumption than lumpier (obviously would rather have 3 meals every day then 6 meals per day in November and no food in December) For that reasons we don’t like recessions very much-even if temporary they hurt at the time Fiscal policy is one way of smoothing things-we try to provide some insurance during recessions so that things are better during a recession (and then presumably a bit worse during booms) 3

4 How Nondiscretionary Fiscal Policy Works Nondiscretionary fiscal policy consists of policies that are built into the system so that an expansionary or contractionary stimulus can be given automatically. Unemployment insurance, the progressive income tax, and welfare serve as the built-in policies. If the economy is in recession, those who lose their jobs are granted unemployment and/or welfare benefits and they owe less in taxes. If the economy is growing at an unsustainable rate, people are making a lot of money and are faced with higher tax rates and there are fewer people eligible for government benefits. 4

5 How Discretionary Fiscal Policy Works If we are in a recession the fiscal policy to stimulate the economy would consist of Government buying Stuff Government paying people to do stuff Decrease in taxes Giving money directly to people If we are in an inflationary period the fiscal policy to contract the economy would consist of just the opposite (I will focus on the first one since it is more relevant) 5

6 Expansionary Fiscal Policy i 6 Real GDP Price Index

7 Shocks A Shock is any unanticipated economic event. – Aggregate Demand Shock : an unexpected event which causes aggregate demand to increase or decrease, e.g. the Sept 11, 2001 terrorist attacks. – Aggregate Supply Shock : an unexpected event which causes aggregate supply to increase or decrease, e.g. Iraq’s 1990 invasion of Kuwait and threat to Saudi Arabia. 7

8 Expansionary Fiscal Policy In response to a Demand Shock 8 Real GDP Price Index We start out here Then get hit by an aggregate demand shock The Nondiscretionary fiscal policy undoes some of it The Discretionary policy takes it up further

9 Expansionary Fiscal Policy In response to a Supply Shock 9 Real GDP Price Index We start out here Then get hit by an aggregate supply shock The Nondiscretionary fiscal policy undoes some of it The Discretionary policy takes it up further

10 The Multiplier This isn’t in the book, but is a very important issue when thinking about fiscal policy If I get $100 richer, I take my family out to a $100 dinner and leave nice $20 tip The server takes her $20 tip and uses it to buy a $12 umbrella The umbrella store guy buys a burrito etc. The bottom line is a $100,000,000 stimulus might boost GDP by more than $100,000,000 This is the main argument for a stimulus or a job creation package It depends on the marginal propensity to consume There are major fights about this in the popular press between various economists about this 10

11 Limitations More than anything: there is no free lunch. If you lower taxes or spend money today you need to raise taxes tomorrow. Even if there is a large positive effect today there should be a large negative effect tomorrow Plus there is deadweight loss of taxation so overall effects might be negative 11

12 Ricardian Equivalence Some people argue it should be zero (Ricardian Equivalence) Suppose interest rate is 10% and you give me $1000 today but will raise my taxes by $1100 tomorrow. It shouldn’t have any actual effect on my spending, I am not any richer I should just undo it by saving that money to pay my taxes tomorrow However, most economist don’t believe this works perfectly People are not completely aware of what is going on Some of it will be distribution from some people to others Even more, could be redistribution from future generations to current generations 12

13 Further issues Even if this doesn’t happen perfectly, there is reason to believe that it might partly happen Further interest rates will automatically do some of this Government borrows This causes interest rate to go up People choose to save more Hiring workers might also lead to multiplier less than 1 Government hires someone to build a highway That person might have gotten a job doing something else In this case you didn’t necessarily “create a job” for every worker you hire

14 Evaluating Nondiscretionary Fiscal Policy Most economists believe that the built-in stabilizers have had a modestly positive effect on diminishing the severity of modern recessions. 14

15 The Mistiming of Discretionary Fiscal Policy Recognition Lag: the time it takes to measure the state of the economy Administrative Lag: the time it takes for Congress to agree on a course of action with the president Operational Lag: the time it takes for the full impact of a government program or tax change to have its effect on the economy 15

16 Political Problems with Fiscal Policy Expansionary bias is the problem where politicians are more willing to deal with recessions with tax cuts and spending increases than they are to deal with inflationary pressures with tax increases and spending cuts. The Political Business Cycle suggests that politically motivated fiscal policy is used for short term gain just prior to elections 16

17 The Rise, Fall and Rebirth of Discretionary Fiscal Policy Between 1975 and 2001 fiscal policy was pretty much abandoned as a mechanism for controlling the economy. Monetary policy was used to expand or contract prices and GDP. In 2001, the impending recession motivated tax rebates and the Sept. 11 attacks motivated a variety of tax cut and spending increase ideas in Congress. In 2003, the continuing slow growth motivated a renewal of the tax credit rebate idea. 17

18 The 2003 Rebate 18

19 Obama Stimulus Plan Stimulus Plan ElementAmount in Millions Non-Discretionary Fiscal Policy: Unemployment, Welfare, Medicaid$135,832 Aid to States$53,600 Discretionary Fiscal Policy: Tax Cuts$301,135 Discretionary Fiscal Policy: Spending Increases$300,047

20 Current Jobs Package Proposed by President Obama Total amount is around $450 billion Payroll tax cut for businesses and workers Tax breaks to businesses that hire Tax credit to hire long-term unemployed Extend unemployment insurance Tax credit for veterans Help refinance mortgages Tax changes to pay for it(mostly raising taxes on rich) Money for schools Infrastructure projects Prevent teacher, police and firefighter layoffs 20