Macroeconomic Analysis and Policy

Session:11
Prof. Biswa Swarup Misra
Dean, XIMB

Fiscal Policy: The Best Case

The Multiplier Effect: the additional increase in AD caused when
expansionary fiscal policy increases income and thus consumer
spending.

When government spends money, incomes of

certain people rise. As these people spend their
money, incomes of additional people rise and so on.
The greater the multiplier, the greater will be the
effect of the increase in .
G

The Limits to Fiscal Policy

1.Crowding out: The increase in AD is

reduced or neutralized if government
spending reduces private spending.
2.A drop in the bucket: The economy is so
large that government can rarely increase
spending enough to have a large impact.
3.A matter of timing: It can be difficult to time
fiscal policy so that the AD curve shifts at
just the right moments.

The Limits to Fiscal Policy:

Crowding Out
1.

Crowding Out: The decrease in private spending that occurs when

government increases spending.

Government borrowing can squeeze out private

borrowing especially if the pool (of funds) is limited.

The Limits to Fiscal Policy:

Crowding Out
Two forms of Crowding Out

1) Raising Taxes to Finance Fiscal Policy

Higher taxes reduce private spending.

The greater the fraction of additional income that is

spent, the greater will be crowding out.

Implication: Fiscal policy will be most

effective when people are otherwise afraid to
spend their money.

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The Limits to Fiscal Policy: Crowding Out

A tax-financed increase in government spending is the most straight
forward case for understanding crowding out.
In this case, the increase in spending by the government is paid for by
raising taxes on the private sector. Higher taxes on the private sector
mean less money available for spending there. Thus, the increase in
government spending crowds out spending in the private sectorprimarily spending by consumers in this case, since consumers pay
the largest share of the governments tax revenue.
Note that if $300 billion in new government spending (and, thus,
$300 billion in higher taxes) reduces private consumption by $270
bil-lion (assuming consumers would have spent $270 billion of the
foregone taxes and saved the other $30 billion), then the net increase
in total spending is only $30 billion.
This means the net stimulus from the policy will also be the net
increase in total spending of $30 billion-a far cry from the multiplier
effect for the best-case scenario.

Subtle Detail
One subtle detail of the $300 billion increase in government spending
above is the amount consumers would have spent on their own. Notice
in the example above that consumers are saving only 10 percent (or
$30 billion) of the foregone disposable income.
Suppose the amount that would have been saved is higher-say 50
percent.
This means the net increase in spending resulting from the fiscal
policy is now $150 billion. The stimulative effect of the policy is
larger, and the amount of crowding out is smaller, when
consumers are less willing to spend on their own.
Fiscal policy is likely to be more effective in stimulating the economy
when the private sector is for some reason wary of spending.
This explains why one of the conditions for the best case scenario for
fiscal policy listed above is that the initial decrease in demand should
result primarily from a reduction in consumption.
The limiting effect of crowding out will be mitigated when consumers
are unwilling to spend on their own.

The Limits to Fiscal Policy: Crowding Out

2) Selling More Bonds to Finance Fiscal Policy

The supply of bonds increases.
Two Sources of Crowding Out
a. Bond prices fall interest rates rise Less
Investment Spending
b. Higher interest rates more savings less private
spending.

Implication: Bond-financed fiscal policy will

be most effective when the private sector is
reluctant to save or invest.
Private spending will be less sensitive to changes
in interest rates.

The Limits to Fiscal Policy:

Crowding Out

Tax Rebates and Tax Cuts

Rebatetaxpayers are handed a check.

Early 2008Bush administration tried to stimulate
AD by sending a total of $168 billion in tax rebates:
$300-$600 per taxpayer.
Result: AD did not increase at all because most of the
money was used to pay down debt.
A problem with tax rebates is that they are not
permanent.

The Limits to Fiscal Policy:

Crowding Out

A Special Case: Ricardian Equivalence

Ricardian Equivalence occurs when people see that
lower taxes today mean higher taxes later. They save
their tax cut to pay future taxes.
Ricardian equivalence describes some people but
not all.
To the extent that this occurs, bond-financed tax cuts
are less effective in the short-run.
How many of us
systematically save tax cuts
to prepare for future
government austerity?

The Limits to Fiscal Policy:

A Drop in the Bucket

2. A Drop in the Bucket

Normally changes in fiscal policy in terms of
percentage of GDP are small.
Most of the non-security discretionary spending is
less than 20% of the federal budget.
Stimulus plan passed under President Obama in
2009largest since WWII.
Spread over 3 - 4 years.
At its peak, it was only about 2% of annual GDP.
September 2010: Unemployment rate still high (8.1%)

The Limits to Fiscal Policy:

A Drop in the Bucket

It is difficult for the government to spend enough

money to have an appreciable effect on the
aggregate economy.
Part of the difficulty here lies in the fact that the
vast majority of the governments budget is
consumed by a few large programs such as
national defense, Social Security, Medicare and
Medicaid, and interest on the national debt.

The Limits to Fiscal Policy:

A Matter of Timing

3. A Matter of Timing
Fiscal policy is intended to correct short-term
problems.
By the time fiscal policy is in place, economic
conditions have often changed.
Relevant lags:
RecognitionProblem must be recognized.
LegislativeCongress must propose and pass a
plan.
ImplementationBureaucracies must implement
the plan.
EffectivenessThe plan takes time to work.
Evaluation and AdjustmentDid the plan work?
Have conditions changed?

The Limits to Fiscal Policy

3.

A Matter of Timing (cont.)

ExampleKennedy Tax Cut
Lowered marginal rates from 91% to 70% at the
top and from 20% to 14% at the bottom.
Rates in between were cut by about 30%.
Discussed in 1961; Proposed in 1962; Enacted
in 1964.
Results:
Had little effect on the economy until 19651967.
Long-term effect on economic growth was
significant.

The Limits to Fiscal Policy

3.

A Matter of Timing (cont.)

Example Bush Tax Cuts
Marginal rates were cut in 2001, 2002, and
2003.
Each cut was less than 1% of GDP.
The economy was already recovering.
Most went to relatively high income groups
who save a larger fraction of their income.
Low income people pay little income tax.
Result:
Little effect on AD.

The Limits to Fiscal Policy

3. A Matter of Timing (cont.)

Monetary policy is also subject to lags, but
Generally shorter than for fiscal policy.
Federal Reserve can act very quickly.
Example: After 9/11, the next day the Fed
stepped in with massive infusions of cash
to the banking system.
Only advantage of fiscal policy is that the
effectiveness lag is shorter.
Monetary policy depends on willingness of
banks to lend and businesses to borrow.

The Limits to Fiscal Policy

3.

A Matter of Timing (cont.)

Automatic Stabilizers: changes in fiscal policy
that stimulate AD in a recession without explicit
action by policy makers.
Welfare and transfer programs
In a recession more people apply for
welfare assistance and unemployment
benefits income C
Consumption smoothing
People drawing on savings during an
economic downturn.
Credit cards can help consumption
smoothing.

The Limits to Fiscal Policy

Government Spending versus Tax Cuts as

Expansionary Fiscal Policy
Differences are political as well as economic
Political differences
Tax cutputs more money into the private
sector, Bush (Republican) favored tax cuts.
Spendinggrows government, Obama
(Democrat) focused on spending.
Economic difference
Government spending is spending by
definition.
Tax cuts will increase spending only if
people dont save their new money.

The Limits to Fiscal Policy

4.

Real Shocks
Fiscal policy does not work well to combat real shocks.

Real shocks reduce the productivity of labor and

capitalSolow growth curve shifts to the left.
Government responds by increasing G .
Because the economy is at full employment
most of the increase in G will crowd out private
spending.
Most of the effect shows up as p.
Lets use our model to show how this works.

The Limits to Fiscal Policy:

A Matter of Timing

3. A Matter of Timing
Monetary policy is also subject to lags, but:
Generally shorter than for fiscal policy.
Federal Reserve can act very quickly.
The day after 9/11 the Fed stepped in with
massive infusions of cash to the banking system.
Only advantage of fiscal policy is that the
effectiveness lag is shorter.
Monetary policy depends on willingness of banks
to lend and businesses to borrow.

Automatic Stabilizers
Fiscal Policy instruments are counter cyclical in nature and as
such act as automatic stabilisers.

Suppose economic growth is above potential

This implies too much demand. Policy should be directed to

dampen excess demand associated with very high growth.

Taxes which are instruments of fiscal policy attain this without
any policy measure. How? If the tax system is progressive, more
people enter the higher tax bracket when economic growth is
very high. Higher taxes takes out a part of the demand that what

would have otherwise would have been there without taxes.

The Limits to Fiscal Policy

Government Spending versus Tax Cuts as Expansionary

Fiscal Policy
Differences are political as well as economic
Political differences

Tax cutputs more money into the private sector, Bush

(Republican) favored tax cuts.
Spendinggrows government, Obama (Democrat)
focused on spending.
Economic differences
Government spending is a more certain influence on the
economy, but is slower.
Tax cuts will increase spending only if people dont save
their new money.

Limits to Fiscal Policy

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