Chapter 17

Fiscal Policy

Fiscal Policy and the Budget Process

Fiscal policy is the government’s policy with respect to its budget position (G-T)

Ceteris paribus, big budget deficits (G>T) are stimulative, adding demand to the economy

Big budget surpluses (G<T) are contractionary, taking demand out of the economy

Fiscal Policy and the Budget Process

US budget process Congress and the President come up with

the plan for taxing and spendingBudget covers one year

Fiscal Policy and the Budget Process

Deficit is a one year shortfall National debt – the cumulative effect of

years of deficitsIf there were deficits in previous years,

there will be interest that has to be paid on the national debt

Interest is paid to the bondholders

Fiscal Policy and the Budget Process

If the government doesn’t pass a budget The Treasury department couldn’t pay the

interest on that debtThe government would default on its debt

obligationsThis has never happened in the U.S.

Fiscal Policy and the Budget Process

Such a default would Undermine confidence of lendersThis makes it harder for a nation to get

capital flows into their countryThis is an issue for many developing

nations, as we will see later

Implementation of Fiscal Policy

If there is unemployment,

Government can change its budget position to stimulate the economy

It can raise G,

or cut T,

or both

In order to move AD right

P

AS

Figure 17.2.1 - Recession and Fiscal Stimulus

Y

AD'

Y' YFY*

Effect of FiscalStimulus

LAS

AD

A carefully planned intervention

Can move the economy to full employment

May cause inflation due to the shape of the AS line

May cause other problems, too

17.2.2

When the government runs a deficit,

it has to make up the difference by borrowing

The source for the borrowing is the capital market

We’ve always used DI for the demand for private investments

Now, we have the government’s demand for capital to cover its debts, which we’ll call DG

r

Figure 17.2.2 - Government Borrowing and the Capital Market

Q$

S

r1

r0

TQ0 TQ1

DI

DI + DG

This additional demand

causes higher interest rates

Some private investors may not borrow to do projects they would have done,

because the higher interest rates make the project less worthwhile

Economists call this crowding out

17.2.3 The crowding-out effect

Figure 17.2.3 - Crowding-Out Effect

r

Q$

S

r1

r0

I0=TQ0 TQ1

DI

DI + DG

Amount that Gov.Borrowing Droveup Interest Rate

I1

Amount Of Private Investment CrowdedOut by Government Borrowing

Capital to PrivateInvestment:

Before Gov. Entry

After Gov. Entry

.

Capital to Gov.

Before the government entry,

the interest rate was r0,

total capital was TQ0

Since all capital was going toward private investment,

private investment, I0 , was equal to TQ0

With the government entry due to the budget deficit,

interest rates rise to r1,

and total capital exchanged moves out to TQ1

However, private investment at the new rate of r1 is only I1

you lose investment from I0 to I1

we say this investment is “crowded out”

Understand that

private investor’s demand has not changed

The higher interest rate just makes fewer investments worthwhile

The size of the crowding out effect depends on

the elasticity of the capital supply curve

Inelastic - large crowding out

Elastic - small crowding out

Figure 17.2.4 - Elasticity of Capital Supply and the Size of the Crowding-Out Effect - Cases

r

Q$

S

Elastic Case Inelastic Case

DI

I1 I0

+ DGDI

r1

r0

r

Q$

S

DI

I1 I0

+ DGDI

r1

r0

17.2.4

Governments demanding capital due to big budget deficits may bring other changes

If suppliers think this budget deficit is a wise policy,

then their confidence may increase the supply of capital to the nation’s capital markets

This may diminish the crowding-out effect

However,

If the government’s budget deficits seem irresponsible,

and suppliers seem less confident,

their withdrawal of capital may raise interest rates even further and make

the crowding-out effect and fall in I even greater

17.2.5

The government budget position will also have an effect on

international capital flows

These flows will, in turn, affect the trade balance

Figure 17.2.5 - Government Borrowing and the Exchange Rate, Ceteris Paribus

r

Q$

S

DI

+ DGDI

r1

r0

$

S

D

Q0 Q1

D'

C

0C

1C

Suppose, ceteris paribus,

The U.S. government runs a big budget deficit

Higher interest rates cause some capital to flow into the U.S.

The demand for dollar increases, the supply of Euros increases, and

the dollar becomes strongerMore imports, less exports, and AD moves

back leftward

17.2.6

All these problems (crowding out, higher interest rates, stronger dollar, etc.)

can be avoided if the Fed is willing to expand the money supply

This is called monetization of the deficit

The problem with this is that,

as with any money supply expansion,

it may set off inflation

17.3.1

Non-interventionists argue that

using expansionary fiscal policy isn’t necessary

They think unemployment will fix itself, as demand deficient unemployment

leads to lower wages, which move AS downward

17.3.2

Non-interventionists feel expansionary fiscal policy is not only unnecessary,

but fruitless and distortingIn trying to move AD right by running budget

deficits, crowding out will cause I to fall (moving AD

left) and cause a stronger dollar which increase

M and decreases X (also moving AD left)

Further,

If the these problems are small, or if the Fed works to offset them,

you get the risk of inflation or a wage-price spiral

17.3.3

Interventionists feel fiscal policy is a powerful tool

which can help millions who are suffering in a sluggish economy

They contend that “waiting for markets to adjust”

is not helpful, and non-intervention is naive

17.3.4

Non-interventionists point out that

fiscal policy is especially difficult to implement

because of political considerations

Fiscal policy is not only determined by the President,

but by 535 members of Congress

At least monetary policy is in the hands of a small body (Fed) and one chairman (Bernanke)

Every politician wants to

cut taxes and

get more government spending in their particular district

This is politically popular, but the aggregate of these micro choices lead towards a macro tendency of deficit spending

Some non-interventionists feel

the only way to overcome this is to have

a constitutional amendment requiring a balanced budget

This is similar to the idea of a gold standard with monetary policy, because it restricts

government’s ability to influence the economy

17.3.5

Interventionists feel that locking fiscal policy into a balanced budget is foolish

Things come up that demand changes in government spending

Ex. Pearl Harbor, 9/11

17.3.6

Most policy debates are centered around different philosophical positions

Interventionists have little faith in the markets to self-correct due to things like market power and market failure

Non-interventionists have little faith in the government’s ability to solve problems

These two positions

represent the poles in the debateMost economists are in between, but may lean one

way or anotherBoth sides use the same tools you now know to

make their caseIt’s their assumptions that differ