Lecture 15: Fiscal Policy and Demand

Lecture 15: Fiscal Policy and Demand

Outline

• Discretionary Fiscal Policy

• Automatic Stabilizers

• The Fiscal Response to COVID-19

• How Activist Should Countercyclical Policy Be?

Long-Run Spending and Tax Policies

• Impact on Supply Side:

  • Spending and tax policy can affect the supply side of the economy, expanding its potential and increasing the level/growth rate of output over the longer run.

  • Examples:

  • Public research and development can raise technology.

  • Corporate tax reform may increase the capital stock.

  • Increasing educational spending could enhance human capital.

• Additional Goals:

  • Money could also advance other goals, such as national security, climate change mitigation, or poverty alleviation.

Discretionary Fiscal Policy

• Definition:

  • Fiscal policy: Changing spending or taxes to have a short-run impact on the demand side of the economy, often with a counter-cyclical motivation.

  • For example, increasing government spending (G) can increase total income (Y).

• Focus:

  • The focus is on immediate policies affecting capital and labor utilization, rather than longer-run supply-side effects.

  • An illustration: Digging holes and refilling them serves the same economic purpose as building a bridge.

Reasons for Expansionary Fiscal Policy

1. Uncertainty:

   • There is uncertainty about the efficacy of both monetary and fiscal policy, suggesting the use of both.

2. Double Benefits:

   • Expansionary fiscal policy can increase demand while achieving other goals, like protecting vulnerable populations or investing in infrastructure.

3. Low Interest Rates:

   • Interest rates are at zero, yet the economy remains in deep recession.

4. Political Motivation:

   • Political leaders may desire to appear active in the face of recessions or fiscal changes due to other reasons (e.g., wars).

• Note: Contractionary fiscal policy is typically not enacted for counter-cyclical reasons; rather, it is usually motivated by fiscal sustainability concerns.

Stimulus and Aggregate Demand

• Aggregate Demand Dynamics:

  • The question arises: How is the stimulus divided across output or inflation?

  • Falling interest rates stimulate “nominal” demand:
    $Y imes P ext{ (Aggregate Demand)} ext{ where } Y = C imes P_C + I imes P_I + G imes P_G + [X imes P_X - M imes P_M]$

• Real Supply Concerns:

  • If nominal demand rises significantly but supply does not (especially if the economy is at capacity), inflation may result instead of increased output.

The Fiscal Policy Multiplier

• Definition:

  • Fiscal Policy Multiplier:
    $ext{Fiscal Policy Multiplier} = rac{ riangle Y}{ riangle G} ext{ or } rac{ riangle Y}{ riangle T}$

• Direct Effect:

  • Expansionary fiscal policy increases income (Y):

  1. Government raises purchases (e.g., builds more roads):
     $Y ext{ increases resulting in } C(Y - T, r) + I(Y, r) + G + (X - M)$

  2. Government cuts taxes or increases transfers:
     $Y ext{ increases resulting in } C(Y, r) + G + (X - M) ext{ where } T ext{ decreases}$

Indirect Effects of Fiscal Policy Multiplier

• Indirect effect #1: Traditional Keynesian multiplier:

  • This multiplier amplifies shocks, including fiscal.

• Mechanism:

  • As a firm’s revenue increases, labor demand shifts right, layoffs and unemployment decrease, household income rises, and consumption increases.

• Higher Multipliers:

  • Money for households with a higher marginal propensity to consume (e.g., lower-income households or those temporarily needing to smooth consumption).

  • Loans for businesses with temporary liquidity needs.

  • Fast-disbursing money (instant spending) has higher impact than long-term projects.

• Indirect effect #2: Crowding Out:

  • When government borrowing leads to higher interest rates, private-sector borrowing can be reduced, thus crowding out investment.

  • Graphical Representation:

  • The graph depicts the relationship between the quantity of credit and the real interest rate.

Example of Crowding Out

• Government borrows $100 billion for infrastructure (G up 100 billion).

• Increased interest rates lead businesses to cut back on investment and households to reduce consumption by $60 billion.

• Final Outcome:

  • Overall demand increases by $40 billion, excluding the traditional Keynesian multiplier.

Effects of Central Bank Choices on Crowding Out

• The central bank can:
  i. Keep interest rates stable (no crowding out, high multiplier).
  ii. Allow moderate interest rate increase (partial crowding out, medium multiplier).
  iii. Intentionally increase rates significantly (full crowd out, zero multiplier).

Summary of Fiscal Policy Effects

• Overall relation:
  $Y ext{ increases due to } C ext{ increase, but } I ext{ decrease, and } G ext{ increase leading to } (X-M).$

• Key Insight:

  • If the increase in consumption (C) outweighs the decline in investment (I), multiplier > 1.

Multiplier Estimates

• CBO Estimates:

  • Unemployment Insurance: 1.2

  • Checks for Individuals: 0.8

  • Assistance to States and Localities: 1.1

  • Business Tax Cuts: 0.1

• Academic Research Estimates:

  • Individual tax cuts range: 0.6 to 1.2

  • Spending increases range: 0.3 to 1.2

Limitations of Fiscal Expansion

• Unlimited fiscal expansions cannot generate sustained output increases because:

  1. Excessive fiscal measures may lead to inflation rather than real output, especially at full potential.

  2. Central banks will likely counteract perceived unwanted fiscal policies to maintain inflation targets (leading to "full crowd out").

  3. There are costs associated with deficits and debt, which will be discussed in future classes.

Discretionary Fiscal Policy vs. Automatic Stabilizers

• Discretionary Fiscal Policy:

  • Consists of new legislation to change spending or taxes based on macroeconomic conditions.

• Automatic Stabilizers:

  • Taxes automatically decrease and spending (e.g., unemployment insurance) increases when the economy weakens.

Examples of Automatic Stabilizers

• Falling family income leads to decreased tax payments.

• Lower income may grant access to government benefits.

• Job loss results in unemployment insurance benefits.

Expanding Automatic Stabilizers

• Strategies:

  1. Increase taxes and spending as a share of the economy.

  2. Implement more progressive taxes/spending.

  3. Introduce more programs that trigger based on macroeconomic conditions.

Fiscal Response to COVID-19

• Response Size:

  • The fiscal response was the largest to an economic crisis (data from various authorities).

• Fiscal Stimulus Comparison:

  • 2008-2010 vs. 2020-2021 fiscal stimuli shown as a percent of GDP.

• International Comparison:

  • The U.S. had a much larger fiscal response relative to other countries during the pandemic.

Disposable Personal Income Changes During the Pandemic

• Transfers dramatically increased disposable personal income (Y - T).

• Measurements include real disposable personal income per capita over time, showing significant increases.

Multiplier Analysis of COVID Fiscal Response

• Effect on Nominal GDP:

  • Estimated effects of fiscal stimulus in response to COVID shown in billions of dollars over time.

  • Observed outcomes after stimulus versus CBO forecasts.

Inflation and Recovery Trends Post-COVID

• Analysis of personal consumption expenditures price inflation over time alongside the unemployment rate.

  • Extremely high inflation was reported.

Debated Issues Post-COVID Response

• Concerns about varying recovery trajectories due to crisis type.

• Hypothetical impacts of different levels of fiscal response on GDP and inflation.

• Finding ways to improve the targeting and timing of fiscal measures in the future.

• Assessing how shifting inflation should influence future policy responses, especially considering debt and inflation costs.

Countercyclical Policy Effectiveness

1. Capabilities:

   • Monetary and fiscal policy can counteract shocks to aggregate demand.

   • They can help recover full employment more quickly.

2. Limitations:

   • Policy cannot sustainably increase growth at full economic potential due to the risk of inflation and investment crowd-out.

Role Assessment: Monetary vs Fiscal Policy

• Monetary Policy:

  • Technocratic, nimble/reversible, effectively unlimited in magnitude, encourages private investments (lowers interest rates), and targets unemployment support.

• Fiscal Policy:

  • Can be politically influenced, with lagged impacts, limited in magnitude (cannot cut below zero), significant scope in achieving goals, and concerns regarding inflation and debt sustainability.

Decision Factors on Countercyclical Policy Activity

• Three key questions must be addressed:

  1. How quickly can the economy adjust naturally?

  2. How effectively can policymakers time interventions?

  3. What are the serious side effects of counter-cyclical policy?

Conclusion

• The level of activism in counter-cyclical policy depends on various economic factors and the ability of policymakers to address associated risks.