Macroeconomic Policies

Fiscal policy  “Fiscal policy” is the government operation of government spending (G) and taxes (T).  Typically we consider the problem of how the government can manipulate G and T so as to control economic variables such as output, inflation, interest rates, etc.  Issues: how fiscal policy can “stabilize” the economy? what about government borrowing and public debt?

Budget Deficits & Surpluses  Balanced budget: A situation in which current government revenue from taxes, fees, and other sources is just equal to current government expenditures. A situation in which current government revenue from taxes, fees, and other sources is just equal to current government expenditures.  Budget deficit: A situation in which total government spending exceeds total government revenue during a specific time period, usually one year. A situation in which total government spending exceeds total government revenue during a specific time period, usually one year.  Budget surplus: A situation in which total government spending is less than total government revenue during a time period, usually a year. A situation in which total government spending is less than total government revenue during a time period, usually a year.

 The Role of Fiscal Policy  Expansionary fiscal policy: increasing the budget deficit (G↑ or T↓) usually in a recession.  Contractionary fiscal policy: decreasing the budget deficit (G↓ or T ↑) usually in an economic boom.

Real Domestic Output, GDP Price Level AD 2 Recessions Decrease Aggregate Demand AD 1 $5 Billion Additional Spending Full $20 Billion Increase in Aggregate Demand AS $490$510 P1P1 Expansionary Fiscal Policy

Real Domestic Output, GDP Price Level AD 3 Recessions Decrease Aggregate Demand AD 4 $5 Billion Initial Decrease In Spending Full $20 Billion Decrease in Aggregate Demand AS $510$522 P1P1 Contractionary Fiscal Policy

Types of fiscal policy  We differentiate two types of fiscal policy: Discretionary fiscal policy: This is fiscal policy that comes about from planned changes in G and T that the government brings in in response to the economic situation. Discretionary fiscal policy: This is fiscal policy that comes about from planned changes in G and T that the government brings in in response to the economic situation. Non-discretionary fiscal policy: This is fiscal policy that comes about from the design of spending and taxes. There is no government official actively determining these changes. Non-discretionary fiscal policy: This is fiscal policy that comes about from the design of spending and taxes. There is no government official actively determining these changes.

Non-discretionary fiscal policy  Certain parts of our spending and taxes automatically increase demand in a recession (when AD potential GDP). Welfare spending and unemployment benefits are part of G and increase in a recession and decrease in a boom. Welfare spending and unemployment benefits are part of G and increase in a recession and decrease in a boom. Income and company taxes are part of T and depend on GDP, they increase during a boom and decrease during a recession. Income and company taxes are part of T and depend on GDP, they increase during a boom and decrease during a recession.  These act as “automatic stabilizers” on the economy, reducing the variability of the economy.

Cyclically-adjusted budget deficits  The automatic stabilizers raise the budget deficit in a recession and lower the budget deficit in a boom.  This fact means that we can not just look at the budget deficit to determine whether the government is “overspending”, we also have to take into account where we are in the business cycle.  Adjusting the budget deficit for the point we are in the business cycle is called “cyclically adjusting”. We would expect even a “sensible” government to be in a deficit in a recession.

Discretionary fiscal policy  Discretionary fiscal policy is the manipulation of G and T by government officials typically to reduce the severity of shocks to the economy.  It sounds like a good idea, but how does it work in reality?  There are many problems and limitations to the use of fiscal policy to reduce recessions and booms.

Problems with discretion  Scenario: Imagine a train driver that has only one control- an accelerator/brake that he or she can push or pull on to control the train. This is exactly the same situation as the government faces with fiscal policy.  Now what limitations can the train driver face?

Problems with discretion  Limitations: Correctness of data: Is the train driver seeing the tracks correctly? Or Does the government get the right data about where the economy is? Correctness of data: Is the train driver seeing the tracks correctly? Or Does the government get the right data about where the economy is? Timing of data: Is the train driver seeing the tracks with enough time to react? Or Does the government get the statistics quickly enough to do anything? Timing of data: Is the train driver seeing the tracks with enough time to react? Or Does the government get the statistics quickly enough to do anything? Decision lags: Can the train driver make a decision about the correct action before the train reaches the problem spot? Or does the government have time to design the correct fiscal policy? Decision lags: Can the train driver make a decision about the correct action before the train reaches the problem spot? Or does the government have time to design the correct fiscal policy?

Problems with discretion Administration lags: If the driver pulls on the control, how long will it take for the brakes to start to work? Or New spending and taxes have to be passed through parliament, which takes time, even after a decision is made. Administration lags: If the driver pulls on the control, how long will it take for the brakes to start to work? Or New spending and taxes have to be passed through parliament, which takes time, even after a decision is made. Operational lags: If the brakes start to work, how long before the train slows down? Or New government spending and taxes take time to affect the economy. Operational lags: If the brakes start to work, how long before the train slows down? Or New government spending and taxes take time to affect the economy.  So even the best-designed fiscal policies can go wrong if they are in response to the wrong data or if they take too long to affect the economy.

Crowding out  The tendency for an increase in govt purchases of goods and services to bring a decrease in investment  Crowding-out effect: A reduction in private spending as a result of higher interest rates generated by budget deficits that are financed by borrowing in the private loanable funds market. A reduction in private spending as a result of higher interest rates generated by budget deficits that are financed by borrowing in the private loanable funds market.