Ch. 18 Fiscal Policy Notes

Introduction to Fiscal Policy

• In February 2020: U.S. economy at full potential, unemployment at 3.5%.

• By April 2020: 17 million job losses; unemployment soared to nearly 15% due to the COVID-19 pandemic.

• Governments historically use fiscal policy to stimulate the economy during downturns (e.g., post-2008 financial crisis), but strategies differed due to the pandemic's nature.

What is Fiscal Policy?

• Definition: Fiscal policy refers to the federal government’s approach involving taxes, spending, and borrowing to influence economic activity.

Why Should Fiscal Policy Work?

• Full Employment:

  • Full employment means increased government spending does not boost output significantly; rather, it reallocates resources.

  • Crowding out occurs when government spending lowers private sector production, making GDP effect minimal.

• Unemployment Impact:

  • If government spending utilizes previously inactive resources, it directly enhances GDP.

  • The Multiplier Effect explains how initial fiscal expenditures can lead to further economic activity as income increases.

• Sticky Wages:

  • Wages adjust slowly, and without fiscal intervention, the economy may not return quickly to its potential output following negative shocks.

The Size and Impact of the Multiplier

• Crowding Out vs Multiplier Debate:

  • If government spending completely crowds out private sector activity, the multiplier effect equals zero.

  • Complete lack of crowding out leads to a multiplier of 1; greater than 1 implies government spending spurs additional private sector activity.

• Multiplier SIZE Factors:

  • Significant when unemployed resources are abundant.

  • Tax cuts should target members likely to spend immediately.

  • Less crowding out leads to a higher multiplier.

Limitations to Fiscal Policy

• Yearly Changes:

  • Yearly federal budget adjustments are often limited, affecting the potential effectiveness of fiscal policy changes.

• Timing Issues:

  • Lags: Recognition lag, Legislative lag, Implementation lag, and Effectiveness lag where each phase consumes time before policy impacts are felt.

• Automatic Stabilizers:

  • Fiscal policies that automatically respond to economic downturns without explicit action, enhancing private spending during recessions.

Government Spending vs Tax Cuts

• Differences in Approach:

  • Tax cuts increase private sector spending, while government spending directly places funds in the public sector.

  • Effective public investment can yield extensive benefits (school improvements, infrastructure).

Fiscal Policy and Real Shocks

• Effects of Real Shocks:

  • Real shocks, like the COVID-19 pandemic, shift the long-run aggregate supply (LRAS) leftwards, leading to higher inflation rather than growth despite government spending.

• Common Sense Fiscal Policy:

  • A counter-cyclical approach advocates increasing spending during recessions and reducing it in booms to stabilize economic fluctuations.

Takeaways on Fiscal Policy Effectiveness

• Most effective under conditions of:

  • Short short-run economic boosts.

  • Aggregate demand deficiencies, absent of real shocks.

  • Targeted fiscal stimulus on the unemployed.

  • Efficient government spending strategies.

• The ongoing debate involves balancing the potential physical crowding out with multiplier benefits within diverse fiscal policies.

In February 2020, the U.S. economy was experiencing full potential, characterized by an unemployment rate of 3.5%, which reflected a strong labor market and robust economic activity. However, by April 2020, the landscape drastically changed as the COVID-19 pandemic resulted in the loss of 17 million jobs, causing the unemployment rate to skyrocket to nearly 15%. This unprecedented situation prompted governments to utilize fiscal policy as a tool for economic stimulation during downturns, similar to actions taken after the 2008 financial crisis. The strategies employed during the pandemic differed significantly due to its unique nature, requiring tailored responses to mitigate severe economic impacts.

What is Fiscal Policy?

Definition: Fiscal policy is defined as the federal government’s strategies involving changes in taxes, public spending, and borrowing with the objective of influencing overall economic activity. It is a key component of economic management alongside monetary policy, which is controlled by the central bank.

Why Should Fiscal Policy Work?

Full Employment:
In an economy at full employment, increased government spending is unlikely to lead to significant gains in economic output; instead, it reallocates existing resources. This phenomenon can lead to 'crowding out', where government spending can potentially reduce private sector investment, limiting overall impacts on GDP.

Unemployment Impact:
When government spending effectively utilizes previously inactive resources, it can lead to a direct enhancement of GDP. This is further explained by the Multiplier Effect, where initial fiscal expenditures generate additional economic activity as incomes rise, resulting in increased consumption and investment.

Sticky Wages:
The concept of sticky wages refers to the slow adjustment of wages in response to changing economic conditions. Without sufficient fiscal intervention, the economy may exhibit prolonged periods of non-optimal performance, failing to return to its potential output after negative shocks, such as recessions or pandemics.

The Size and Impact of the Multiplier

Crowding Out vs Multiplier Debate:
An important debate surrounding fiscal policy is whether government spending crowds out private sector activity. If complete crowding out occurs, the multiplier effect would equal zero. Conversely, if there is no crowding out, the multiplier could be greater than 1, indicating that government spending positively spurs private sector growth.

Multiplier SIZE Factors:
The effectiveness of the multiplier is often significant when there are abundant unemployed resources in the economy. Additionally, tax cuts are most effective when targeted at individuals who are likely to spend immediately, thereby maximizing their impact. Reduced crowding out also correlates with higher multiplier effects, enhancing overall economic benefits.

Crowding out refers to a situation where increased government spending leads to a reduction in private sector investment. This occurs because when the government borrows to fund its spending, it can push up interest rates, making it more expensive for private individuals and companies to borrow. As a result, the overall impact on GDP from government spending may be minimal, if not completely offset, by the decline in private spending. This is an important consideration in fiscal policy debates, as complete crowding out would imply that the multiplier effect of government spending on the economy is zero.

Aggregate demand refers to the total quantity of goods and services demanded across all levels of the economy at a given overall price level and within a specific time period. It encompasses the total demand from households, businesses, government, and foreign entities for domestically produced goods and services. Aggregate demand is typically represented by the equation:

AD = C + I + G + (X - M)

Where:

• C = Consumption by households

• I = Investment by businesses

• G = Government spending

• X = Exports

• M = Imports

Changes in aggregate demand can have significant implications for economic growth, inflation, and employment levels, making it a crucial concept in understanding fiscal and monetary policy effects.

Aggregate demand refers to the total quantity of goods and services demanded across all levels of the economy at a given overall price level and within a specific time period. It encompasses the total demand from households, businesses, government, and foreign entities for domestically produced goods and services. Aggregate demand is typically represented by the equation:

AD = C + I + G + (X - M)

Where:

• C = Consumption by households

• I = Investment by businesses

• G = Government spending

• X = Exports

• M = Imports

Changes in aggregate demand can have significant implications for economic growth, inflation, and employment levels, making it a crucial concept in understanding fiscal and monetary policy effects.

Monetary Policy: Refers to the actions undertaken by a nation's central bank to control money supply and interest rates in order to achieve macroeconomic objectives such as controlling inflation, consumption, growth, and liquidity. Central banks utilize various tools, including open market operations, discount rates, and reserve requirements, to influence the amount of money circulating in the economy.

Fiscal Policy: Involves the federal government's approach to taxation, spending, and borrowing aimed at influencing economic activity. It is used to stimulate the economy during downturns or to cool it off during periods of growth. Fiscal policy tools include government spending on infrastructure, healthcare, or education, as well as adjustments to tax rates to affect overall demand in the economy.

Aggregate Demand Shocks refer to unexpected changes in the total quantity of goods and services demanded in an economy at a given price level. These shocks can arise from factors such as sudden changes in consumer confidence, fiscal policy adjustments, or significant fluctuations in exports and imports. They can lead to rapid changes in economic activity, affecting output and employment levels. For instance, a sharp increase in consumer spending can lead to demand-pull inflation, wherein demand outpaces supply, resulting in rising prices.

Real Shocks, on the other hand, refer to unexpected events that affect the production capacity of an economy. These shocks shift the long-run aggregate supply (LRAS) either leftward or rightward. Examples of real shocks include natural disasters, significant technological advancements, or substantial changes in resource availability. Unlike aggregate demand shocks, real shocks impact the economy's potential output and can lead to structural changes in economic dynamics, such as higher inflation or changes in productivity levels, despite government spending or fiscal stimulus efforts being applied directly to stimulate demand.

Contractionary Fiscal Policy: This type of fiscal policy is implemented to reduce government spending or increase taxes. Its objective is to slow down economic growth when the economy is overheating, characterized by high inflation rates. By decreasing the amount of money circulating in the economy, contractionary fiscal policy aims to stabilize prices and prevent the economy from experiencing negative consequences associated with excessive growth, such as demand-pull inflation.

Expansionary Fiscal Policy: In contrast, expansionary fiscal policy involves increasing government spending or lowering taxes to stimulate the economy. This approach is used during periods of economic downturn or recession to encourage increased consumer spending and investment. By injecting more money into the economy, expansionary fiscal policy aims to boost aggregate demand, increase employment levels, and promote economic recovery.

Key Differences:

• Objective: Contractionary aims to slow down the economy (reduce inflation), while expansionary seeks to stimulate economic growth.

• Government Actions: Contractionary involves reducing spending or increasing taxes; expansionary involves increasing spending or reducing taxes.