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Understanding Fiscal Policy

Michael T. Owyang

Federal Reserve Bank of St. Louis

June 18, 2014

Disclaimer

The following presentation does not reflect the views of the Federal Reserve Bank of St. Louis, the Board of Governors, or the Federal Reserve System.

What is Fiscal Policy? • One of the tools

used to stabilize the economy

• Involves government spending and taxation

What is Fiscal Policy? Expansionary

financed by taxes, borrowing, or

seigniorage

Contractionary

Total Federal Spending

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

1980 1995 2010

Bil

lio

ns

of

2009 U

SD

Bil

lio

ns

of

2009 U

SD

Recession Real GDP

Government Spending Tax Receipts

Where Does All the Money Go?

Social security, 22.0%

National Defense, 18.7%

Income Assistance,

15.5%

Medicare, 11.5%

Health, 10.2%

Net Interest, 7.1%

Education & Social Services,

3.8%

Transportation, 3.1%

Veterans, 2.6% Other, 5.4%

2003 Government Outlays

Social security, 21.9%

National Defense, 19.2%

Income Assistance,

15.3%

Medicare, 13.3%

Health, 9.8%

Net Interest,

6.2%

Education & Social Services,

2.6%

Transportation, 2.6%

Veterans, 3.5% Other, 5.6%

2013 Government Outlays

The Accounting Identity

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

When macroeconomists think of G, it includes government consumption, investment, and payroll

– Things like building bridges, buying tanks, paying army salaries

– Transfers, which are redistributional (e.g., welfare, social security, etc…), are typically excluded

government spending net of transfers

Output and Expenditure E

(P

lan

ned

Exp

en

dit

ure

)

Y (Income, Output)

Y = E

E1

E2

If there is an increase in government spending…

… output increases by more than the increase in government spending.

Y2 Y1

The Multiplier Effect Suppose you consume a fixed fraction of your disposable income, C:

),( TYcC

Lump Sum Tax

Marginal Propensity to Consume

The Multiplier Effect

We can rewrite this as:

or

GIcTYc )1(

Gc

Ic

Tc

cY

1

1

1

1

1

The Multiplier Effect

Let’s say we increase G by 1 dollar and give it to Mary, who then gives it to Barb, who gives it to Shannon. All of them have an MPC of 0.9

Mary spends $0.90

Barb spends $0.81

Shannon spends $0.73

Using T and G Together If taxes and spending are raised the same amount (i.e., a balanced budget), how does this affect Y?

In this case, the multiplier (m) is 1:

Why?

m =1

1- c-c

1- c=

1- c

1- c=1

The Tax Multiplier The tax multiplier and the spending multiplier are different.

The tax multiplier is:

1,1

1

1

c

cc

c

The Tax Multiplier Why is this different?

• Spending is a direct injection (i.e., it raises Y directly by the amount of ΔG) and then has secondary effects

• Decreasing taxes increases Y directly by only the amount it raises consumption and then has secondary effects

Supply Siders Why do some advocate for decreased taxes instead of increased spending?

• Some argue that the effect of tax cuts does not only happen through the effect on consumption

• We have modeled tax cuts as an increase in aggregate demand (AD)

• If tax cuts increase investment and technology (through incentives to innovate), aggregate supply (AS) could also shift

Real World Estimates of the Multiplier

• Calculations of the multiplier in the AS-AD framework assume that consumer behavior does not change as we change G or T

• In our simple example, the multiplier is easy to compute

• In reality, there is still a debate over the magnitude of the multiplier

• Monetarists vs. Keynesians Vs. Classicists

Does it Matter How Spending is Financed?

• Perhaps not

• Suppose we increase G now and finance it with an increase in T

• The balanced budget multiplier is 1

Does it Matter How Spending is Financed?

• Suppose instead we finance the increase in G by borrowing

• Consumers may realize that this means T will have to go up eventually

• If rational, they might increase their marginal propensity to save (MPS) which would decrease the multiplier effect

• This is the Riccardian Equivalence

Crowding Out

• An increase in G may also have an effect on the other components of AD

• Let’s assume the total supply of loanable funds is fixed

• Then, an increase in G that is deficit financed means there must be an increase in r

• The government is essentially competing with the private sector for loans

Crowding Out

• If r increases, investment falls (the private sector cannot get loans for capital investment)

• This is called crowding out

Crowding Out • Crowding out can occur in net exports

as well • If an increase in G leads to an increase

in r, foreign capital flows in • This makes the dollar appreciate (an

increase in the demand for dollars) • This makes U.S. goods relatively more

expensive than foreign goods • Net exports fall as a result

Section Break

Taxes Can Be Distortionary

• Lump sum taxes, because they are paid regardless of consumption/income, do not change behavior

• Per unit taxes can change behavior

• A per unit tax is like a change in price

Taxes Can Be Distortionary P

rice

Quantity

D

S1

S2

T

Deadweight Loss

If the government imposes a per-unit tax…

Pigouvian Taxes

• But taxes can also aid in efficiency

• If there are externalities, a competitive market can overproduce

• A per unit tax can cause a market distortion that lowers the amount sold

• If the tax is equal to the amount of the externality, it allows the market to effectively “internalize” the externality

Final Thoughts