Macroeconomics 2

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Fiscal Policy

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is the use of taxes, government transfers, government purchases of goods and services or investment tax credits to shift the aggregate demand curve.

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Investment Tax Credits

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An investment tax credit is a tax break given to firms based on their investment spending. This increases the incentive for investment spending.
 Investment tax credits are often temporary, applying only to investment spending within a specific period.
 Like department store sales that encourage shoppers to spend a lot while the sale is on, temporary investment tax credits tend to generate a lot of investment spending when they’re in effect. Even if a firm doesn’t think it will need a new computer server or lathe for another year or so, it may make sense to buy it while the tax credit is available, rather than wait.

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Expansionary Fiscal Policy

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Can close a recessionary gap by increasing aggregate demand

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Contractionary Fiscal Policy

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Can eliminate an inflationary by reducing aggregate demand

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Reason for caution in Fiscal Policy

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Significant Lags in its use

Realize the recessionary/inflationary gap by collecting and analyzing economic data  takes time
 Government develops a spending plan takes time
 Implementation of the action plan (spending the money  takes time

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Japan and Fiscal Policy

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Japan turned to expansionary fiscal policy in the early 1990s.  At the end of the 1980s Japan’s bubble burst—stock and
land values plunged.  During the years that followed, Japan relied on large-scale
government purchases of goods and services, mainly in the form of construction spending on infrastructure, to prop up aggregate demand.
 This spending was scaled back after 2000, but at its peak it was truly impressive. In 1996 Japan spent about $300 billion on infrastructure.
 Was this policy a success? Yes and no.  Many economists believe that without all that government
spending, the Japanese economy would have slid into a 1930s-type depression after the bursting of the bubble economy.
 Instead, the economy suffered a slowdown but not a severe slump.

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Fiscal Policy has a Multiplier Effect

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 Expansionary fiscal policy leads to an increase in real GDP larger than the initial rise in aggregate spending caused by the policy.
 Conversely, contractionary fiscal policy leads to a fall in real GDP larger than the initial reduction in aggregate spending caused by the policy.

 The size of the shift of the aggregate demand curve depends on the type of fiscal policy.
 The multiplier on changes in government purchases, 1/(1 - MPC), is larger than the multiplier on changes in taxes or transfers, MPC/(1 - MPC), because part of any change in taxes or transfers is absorbed by savings.

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Bigger effect on the Economy, Changes in Government Purchases or Changes in Taxes/Transfers?

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Government Purchases

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Effects of fiscal policy with multiplier of 2

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GDP is cut in half each round (1/2)

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Lump-Sum Taxes

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Taxes that don't depend on the tax payer's income

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Automatic Stabilizers

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Act as rules governing taxes and some transfers

reducing the size of the multiplier and automatically reducing the size of fluctuations in the business cycle.

opposite is discretionary fiscal policy

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Discretionary Fiscal Policy

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arises from deliberate actions by policy makers rather than from the business cycle.

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Government Savings (Sg)

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Sg= T-G-TR

Other things equal, discretionary expansionary fiscal policies—increased government purchases of goods and services, higher government transfers, or lower taxes—reduce the budget balance for that year.

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Budget Balance and Expansionary Fiscal Policy

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make a budget surplus smaller or a budget deficit bigger.

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Budget Balance and Contractionary Fiscal Policy

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smaller government purchases of goods and services, smaller government transfers, or higher taxes—increase the budget balance for that year, making a budget surplus bigger or a budget deficit smaller.

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Cyclically Adjusted Budget Balance

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an estimate of the budget balance if the economy were at potential output.

separates the effects of the business cycle from the effects of discretionary fiscal policy

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Budget Deficit as a Percent of GDP rises during recessions and falls during expansions

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rises during recessions and falls during expansions

Also moves closely tandem with the unemployment rate

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Most economists don’t believe the government should be forced to run a balanced budget every year because...

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this would undermine the role of taxes and transfers as automatic stabilizers.
 Yet policy makers concerned about excessive deficits sometimes feel that rigid rules prohibiting—or at least setting an upper limit on—deficits are necessary.

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US budget accounting

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calculated on the basis of fiscal years

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fiscal year

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runs from October 1 to September 30 and is labeled according to the calendar year in which it ends.

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Persistent Budget Deficits

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lead to an increase in public debt

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Deficits vs Debt

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Deficit- is the difference between the amount of money a government spends and the amount it receives in taxes over a given period.

Debt- is the sum of money a government owes at a particular point in time.

Deficits and debt are linked, because government debt grows when governments run deficits. But they aren’t the same thing, and they can even tell different stories.

For example, at the end of fiscal 2008, U.S. debt as a percentage of GDP was fairly low by historical standards, but the deficit during fiscal 2008 was considered quite high.

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Problems with Rising Debt

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Public Debt may crowd out investment spending- which reduces long-run economic growth.

Government Default- resulting in economic and financial turmoil.

If they print more money it causes inflation

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Debt-GDP ratio

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can remain stable or fall even in the face of moderate budget deficits if GDP rises over time.

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WWII Debt

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The government paid for World War II by borrowing on a huge scale. By the war’s end, the public debt was more than 100% of GDP, and many people worried about how it could ever be paid off.
 The truth is that it never was paid off. In 1946 public debt was $242 billion.
 By 1962 the public debt was back up to $248 billion. By then nobody was worried about the fiscal health of the U.S. government because the debt–GDP ratio had fallen by more than half.
 Vigorous economic growth, plus mild inflation, had led to a rapid rise in GDP. The experience was a clear lesson in the peculiar fact that modern governments can run deficits forever, as long as they aren’t too large.

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Implicit Liabilities

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are spending promises made by governments that are effectively a debt despite the fact that they are not included in the usual debt statistics.