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Understanding Fiscal Policy
Michael T. Owyang
Federal Reserve Bank of St. Louis
June 18, 2014
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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.
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What is Fiscal Policy? • One of the tools
used to stabilize the economy
• Involves government spending and taxation
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What is Fiscal Policy? Expansionary
financed by taxes, borrowing, or
seigniorage
Contractionary
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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
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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
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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
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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
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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
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The Multiplier Effect Suppose you consume a fixed fraction of your disposable income, C:
),( TYcC
Lump Sum Tax
Marginal Propensity to Consume
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The Multiplier Effect
We can rewrite this as:
or
GIcTYc )1(
Gc
Ic
Tc
cY
1
1
1
1
1
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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
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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
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The Tax Multiplier The tax multiplier and the spending multiplier are different.
The tax multiplier is:
1,1
1
1
c
cc
c
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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
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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
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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
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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
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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
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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
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Crowding Out
• If r increases, investment falls (the private sector cannot get loans for capital investment)
• This is called crowding out
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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
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Section Break
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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
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Taxes Can Be Distortionary P
rice
Quantity
D
S1
S2
T
Deadweight Loss
If the government imposes a per-unit tax…
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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
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Final Thoughts