Macro Chapter 12

Fiscal Policy: Incentives, and Secondary Effects

4 Learning Goals

1) Explain the crowding-out effect2) Identify political incentives associated with

fiscal policy3) Summarize both sides of the debate about the

effectiveness of fiscal stimulus4) Investigate the effect fiscal policy has on

aggregate supply

Fiscal Policy, Borrowing, and the Crowding-Out Effect

Basic components of Crowding-Out:

Y = C + I + G + XIf the government (public sector) spends more, G risesThen businesses, consumers, and foreigners (private sector) spend less, C, I, and X fallNet effect is zero or a small positive increase in Y

First Secondary Effect:When the gov’t spends more, it either needs to borrow more or raise taxes to fund that spendingIf the gov’t borrows more, the demand for loanable funds increases which increases interest ratesWhen interest rates increase, consumers buy less and businesses invest lessIf the gov’t raises taxes, consumers and businesses have less income which causes C and I to fall

Second Secondary Effect:

If the gov’t borrows more, the demand for loanable funds increases which increases interest ratesHigher interest rates will attract foreign investment which will cause the dollar to appreciate (because the demand for the dollar will increase)When the dollar appreciates, US exports fall and imports rise (net exports fall)

Q12.1 The crowding-out model implies that a

1. budget surplus will be highly effective against inflation.

2. budget deficit is likely to stimulate aggregate demand and cause inflation.

3. budget deficit will increase real interest rates and, thereby, reduce private spending.

4. budget surplus will reduce aggregate demand and throw the economy into a downward spiral.

Q12.2 The crowding-out model implies that restrictive fiscal policy will

1. increase aggregate demand and employment.

2. lead to a significant increase in the natural rate of unemployment.

3. be highly effective against inflation.

4. reduce real interest rates.

Fiscal Policy, Future Taxes, and the New

Classical Model

Skim on your own

You are not expected to know details

Political Incentives and the Effective Use of Discretionary Fiscal

Policy

Another problem is the nature of government spending:

Some spending may benefit only a small group of people

Referred to as pork barrel spending

Watch video: Stossel Macro Clip 14- pork barrel spending

Q12.3 Why is legislation such as that to build the bridge in Ketchikan, Alaska, passed when most everyone knows that it is “pork”?

1. The benefits are concentrated to constituents in a part of Alaska while the costs are spread out over millions of taxpayers.

2. The benefits are diffused to millions of taxpayers and the costs are concentrated among special interest groups.

3. Such legislation will create permanent jobs and expand the local economy.

4. When it comes to federal spending, members of Congress often ignore the interests of their home districts.

Fiscal Policy: Countercyclical

versus Response during a Severe

Recession

Will fiscal stimulus speed recovery from a recession?

Argument for Yes:

Only some crowding-out will occur so output will increase

The multiplier is large so an increase in G will have a big effect

Interest rates are weak incentives

Will fiscal stimulus speed recovery from a recession?

Argument for No:

More government spending now will lead to higher interest rates and taxes later

Stimulus spending will increase structural unemployment

Politically driven spending is inefficient

Let’s see, recovery.gov

Watch video about politically driven spending: Stossel- stimulus spending and crony capitalism

Are tax cuts a better tool than government spending?

Argument for Yes:

Tax cuts work faster

Tax cuts are more efficient-you spend your money better than someone else spending it for you

Tax cuts are easier to reverse

Tax cuts increase the incentive to invest and produce

Are tax cuts a better tool than government spending?

Argument for No:

People will save their money rather than spend it

Government spending can be directed to certain areas; tax savings will go different places

Government doesn’t want to give up that revenue

How Much is a Trillion?

Inquiring minds want to know

What does one TRILLION dollars look like?

All this talk about “stimulus packages” and “bailouts”...A billion dollars...

A hundred billion dollars...

Eight hundred billion dollars...

One TRILLION dollars...

What does that look like?

Here’s a hundred bucks

We’ll start with a $100 dollar bill. Currently the largest U.S. denomination in general circulation. Most everyone has seen them, slightly fewer have owned them. Guaranteed to make friends wherever they go.

Serious coin

A packet of one hundred $100 bills is less than 1/2" thick and contains $10,000. Fits in your pocket easily and is more than enough for a week or two of shamefully decadent fun.

One Million Dollars!!!

Believe it or not, this next little pile is $1 million dollars (100 packets of $10,000). You could stuff that into a grocery bag and walk around with it.

That’s what I’m talkin’ about!

While a measly $1 million looked a little unimpressive, $100 million is a little more respectable. It fits neatly on a standard pallet...

Holy cow!

And $1 BILLION dollars... now we’re really getting somewhere...

Please have a seat

Next we’ll look at ONE TRILLION dollars. This is that number we’ve been hearing so much about.

What is a trillion dollars? Well, it’s a million million.

It’s a thousand billion.

It’s a one followed by 12 zeros.

You ready for this?

And notice those pallets are double stacked $100 dollar bills!

So the next time you hear your Congressman toss around the phrase “trillion dollars”... that’s what they’re talking about.

$1 Trillion dollars:

Q 12.4 Historically, Keynesian economists have argued that government spending will stimulate aggregate demand more than tax cuts because

1. government spending will stimulate aggregate demand more quickly than a tax cut.

2. there are fewer adverse side effects to an increase in government spending.

3. all of the spending will add to aggregate demand, but a portion of the tax cut will be saved.

4. an increase in government spending can quickly be reversed once the economy has recovered.

Q12.5 According to non-Keynesians, how will an increase in government spending financed by borrowing during a recession affect recovery?

1. Higher future taxes and interest rates will be required to finance the larger debt and this will weaken the recovery.

2. Repayment of the debt can always be shifted to the future, making it possible to keep tax rates low and thereby strengthen the recovery.

3. Higher interest payments will increase future government spending, and thereby promote a stronger the recovery.

4. The increase in government spending will exert a multiplier effect on the economy, leading to a stronger recovery.

Paradoxes of Thrift and Spending

Skim on your own

The Supply-Side Effects of Fiscal Policy

Class Activity : Make up an annual income for yourself. What is your marginal tax rate? How does that differ from your average tax rate?

Some other details of tax payments

Watch video: Stossel Macro Clip 06- how much taxes do the rich pay

See Mankiw- “I can afford higher taxes” article in Blackboard

Q12.6 If the government cuts the tax rate, workers get to keep

1. less of each additional dollar they earn, so work effort increases, and aggregate supply shifts right.

2. less of each additional dollar they earn, so work effort decreases, and aggregate supply shifts left.

3. more of each additional dollar they earn, so work effort increases, and aggregate supply shifts right.

4. more of each additional dollar they earn, so work effort decreases, and aggregate supply shifts left.

Fiscal Policy of the United States

Here is a brief history of how we arrived at our thinking today

See (again) Supplemental Videos: Commanding Heights 1, Chapters 1 through 8

For more information, see www.pbs.org/wgbh/commandingheights

Or Google “commanding heights”

Question Answers:

12.1 = 3

12.2 = 4

12.3 = 1

12.4 = 3

12.5 = 1

12.6 = 3