FISCAL POLICY

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FISCAL POLICY
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Thanksgiving
FISCAL POLICY
International Finance I
MONETARY POLICY
International Finance II
The Uncertain Multiplier
And Wrap Up
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Fiscal policy

• Focus
• Spending
• distinguish between purchases and spending or
  outlays or expenditures
• Tax revenues
• distinguish between tax rates and tax revenues
• let t tax rate, Y income,
• then tax revenue is T tY
• Government debt
• Todays topics effect of deficit, debt,
  countercyclical policy, structural deficit,
  automatic stabilizers, rules versus discretion

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29_02
Fiscal year 2000
Apr. 1
Jan. 1, 1999
Jan. 1, 2001
July 1
Oct. 1
Jan. 1, 2000
Apr. 1
July 1
Oct. 1
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Federal budget summary (billions of
dollars)Fiscal year 1998 versus 1995
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(No Transcript)
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Deficit versus debt

• When the government runs a deficit, it increases
  its debt
• When the government runs a surplus, it reduces
  its debt
• surplus (98) debt (end 97) - debt (end 98)
• 70 3771.1 - 3701.1
• Government borrows by issuing bonds
• and retires these bonds when in has a surplus

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A graph of the deficit and the debt
BILLIONS
29_03
OF DOLLARS
Debt
3,500
3,000
2,500
2,000
1,500
1,000
500
Deficit
0
-500
1950
1995
1955
1960
1965
1970
1975
1980
1985
1990
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Debt as a share of GDP

• Debt/GDP can stay constant or even fall when
  there is a budget deficit
• Example
• 5 growth of GDP
• then ratio stays constant if
• Debt/GDP Debt(1.05)/GDP(1.05)
• thus 3.7 trillion times (.05) 185 billion
  deficit
• Debt/GDP ratio falls with balanced budget

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Ratio just starting to decline ?
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Long run effect of deficits or surpluses

• The long run effect of a lower deficit or higher
  surplus are those of a lower the share of G in
  GDP---use SAM
• real interest rate lower
• I/Y higher, leading to higher potential growth
• Short run negative effects can be mitigated by
  being gradual, being credible, and letting Fed
  join in (but this is an old issue, now...

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The question is how to use the projected
surplus

• Recent shift from deficit to surplus
• Leave it? Cut taxes? Increase spending?
• The social security problem
• As baby boom generation retires, benefits will
  grow relative to payroll tax revenues
• Will need to reduce benefits or increase taxes
• Some suggest privatizing part of social security

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Countercyclical fiscal policy

• Argues that increasing government spending or
  reducing taxes during a recession would mitigate
  the recession
• Suggested by Keynes in 1930s (Keynesian policy)
• Rationale now for fiscal stimulus package in
  Japan
• Discretionary versus automatic

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Use of countercyclical fiscal policy (G) to bring
the economy back to potential
Potential GDP
INFLATION
29_05
PA
government purchases
REAL GDP
Potential GDP
INFLATION
PA
government purchases
REAL GDP
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Use of countercyclical fiscal policy (taxes) to
bring economy back to potential
Potential GDP
29_06
INFLATION
PA
tax cut
REAL GDP
Potential GDP
INFLATION
PA
increase
REAL GDP
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Case of good timing in using fiscal policy to
hasten the return of real GDP back to potential
GDP
INFLATION
Potential GDP
29_08
Path of economy without
a fiscal stimulus
Path of economy with
a fiscal stimulus
PA
ADI
without
stimulus
stimulus
REAL GDP
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Effect of fiscal policy on the path of real GDP
good and bad timing
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Effect of the economy on the budget deficit

• Budget deficit is cyclical
• Deficit rises in recessions
• Deficit falls during recoveries and expansions
• To see the reason look at tax revenues and
  expenditures

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Government tax revenues depend on the state of
the economy

• when real GDP grows more rapidly, tax revenues
  rise faster
• more people working, higher incomes
• people move into higher tax brackets
• when real GDP grows more slowly, tax revenues
  rise less rapidly
• fewer people working, lower incomes
• people may move into lower tax brackets

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Expenditures also depend on the economy

• When real GDP grows less rapidly or falls, as in
  a recession, expenditures grow more rapidly
• unemployment compensation rises
• welfare payments go up
• more people retire, increasing social security
  payments
• When real GDP grows more rapidly, as in a
  recovery, expenditures grow less rapidly

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Net effect of real GDP on deficit

• deficit government spending - tax revenue
• thus in a recession the deficit will rise, and in
  a recovery the deficit will fall
• Y? implies D?
• government spending ? and tax revenues ?
• Y ? implies D?
• government spending ? and tax revenues ?
• Explains why rosy scenarios make the deficit
  look smaller

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A NEW GRAPH to show the effect of real GDP on the
deficit
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The structural deficit

• The structural deficit is the deficit that would
  exist if real GDP potential GDP
• Also called full employment deficit
• Purpose is to take out (control for) the effects
  of economic fluctuations in real GDP on the
  deficit
• Changing structural deficit requires
• change in tax laws, size of government,...

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Graphical illustration of the structural deficit
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Automatic stabilizers

• The tendency for tax revenues to fall and
  government spending to rise in recessions can
  have a stabilizing effect on the economy
• the changes offset decline in demand during
  recession (as with countercyclical policies)
• these changes are automatic
• occur without executive or legal action
• hence fewer lags, timing is better, overall
  effects can be very large

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Automatic changes in revenues and expenditures
due to recession (FY 1991)
BILLIONS
29_01
OF DOLLARS
1,400
1,324
1,233
1,170
1,200
1,054
1,000
800
600
400
270
200
63
0
Proposed
Proposed
Actual
Proposed
Actual
Actual
Tax Revenue
Expenditures
Deficit
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Rules versus discretion debate in fiscal policy

• Problems with discretion are mainly lags
• recognition, implementation, impact
• Rules ? automatic stabilizers
• Johnson surcharge (1968)
• Bush stimulus package (1992)
• Clinton stimulus package (1993)
• Kennedy tax cut (1964)
• Reagan tax cut (1981-82)???

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END OF LECTURE