Aggregate Demand Policy in Perspective

1
Aggregate Demand Policy in Perspective

• Problems with Fiscal Policy

2
Laugher Curve

• Top Five Reasons to Study Economics

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you are just researching the law of diminishing
marginal utility.
3
Laugher Curve

• Top Five Reasons to Study Economics

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make any.
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4
Laugher Curve

• Top Five Reasons to Study Economics

2. When you are in the unemployment line, at
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5
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.

6
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.

7
Supply Side versus Demand Side Policies

• Politicians are not constrained by models.

• They can, and do, often emphasize different
  interconnections.

8
Demand-Side and Supply-Side Policies
LAS
Supply-side policies shift the LAS curve.
SAS
AD
Demand-side policies (monetary and fiscal
policies) shift the AD curve
YP
9
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 doesnt matter.
• Fiscal policy doesnt negatively affect other
  goals.

10
Financing the Deficit Doesnt Have Offsetting
Effects

• Some economists believe that government financing
  of deficit spending offsets the deficits
  expansionary effect.
• They believe that government borrowing increases
  interest rates and crowds out private investment.

11
Financing the Deficit Doesnt Have Offsetting
Effects

• Crowding out the offsetting of a change in
  government expenditures by a change in private
  expenditures in the opposite direction.

12
Financing the Deficit Doesnt 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.

13
Financing the Deficit Doesnt 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.

14
Partial Crowding Out
AD2
AD1
AD0
SAS
Partial crowding out
Net effect
Y0
Y2
Y1
15
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.

16
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.

17
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.

18
Knowing the Level of Potential Income

• Differences in estimates of potential income
  often lead to different policy recommendations.

19
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.

20
The Governments 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.

21
The Governments Flexibility in Changing Taxes
and Spending

• Squabbles between Congress and the President may
  delay implementing appropriate fiscal policy for
  months, even years.

22
Size of the Government Debt Doesnt Matter

• These is no inherent reason why the adoption of
  activists policies should have caused high
  government deficits year after year.

23
Size of the Government Debt Doesnt 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.

24
Size of the Government Debt Doesnt 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.

25
Fiscal Policy Doesnt Negatively Affect Other
Government Goals

• An economy has many goals achieving potential
  income is only one of those goals
• National economic goals often conflict.

26
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.