Fiscal Policy - Lecture Notes | Principles of Macroeconomics | ECON 102, Study notes of Introduction to Macroeconomics

Download Fiscal Policy - Lecture Notes | Principles of Macroeconomics | ECON 102 and more Study notes Introduction to Macroeconomics in PDF only on Docsity! Fall Semester '01-'02 Akila Weerapana Lecture 16: Fiscal Policy I. OVERVIEW • In the last few lectures we looked at the impact of fiscal and monetary policy on an economy that is in steady state using the AD/PA model. We also looked at how other events like oil price shocks can affect the economy in the short run and the long run. • In today’s lecture, we will look in more detail at how we can use fiscal policy to help an economy that is doing badly to get out of a recession. We will also take a look at how different types of government purchases (more spending on technology vs. more spending on bureaucrats) have different impacts on the economy • Finally, we will closely examine the reasons behind why fiscal policy is easier to model in theory than carry out in practice. We will also look at all government spending, not just government purchases; many of the interesting issues involving fiscal policy involve discussion of the entire government budget . II. EXPANSIONARY FISCAL POLICY IN AN ECONOMY THAT IS IN RECESSION • “Fiscal policy” is a term that is used to refer to government decisions regarding taxation and spending. Expansionary fiscal policy refers to a tax cut or an increase in spending. • First, let’s concentrate on how we can use expansionary fiscal policy to get an economy out of a recession. First let’s think about what caused the recession in the first place: let’s suppose a fall in consumer confidence because consumers become uncertain about the future of the stock market. • The fall in consumer confidence reduces spending and shifts the AD curve in. Output falls to Y1. Over time, even if the government does nothing, inflation will start to fall as firms start to decrease prices. This is shown by the PA line shifting downwards. • As inflation falls, the Fed will lower interest rates and as a result, we will see an increase in output. Since the change in Y is brought about by a change in inflation, this will be captured as a movement along the AD curve. • Eventually the economy will return to potential output with a lower inflation rate but the price we pay for the low inflation is a short run recession. This is shown in Figure 1 below. Inflation Rate Real GDP Y1 Y* AD PA AD’ PA’ Figure 1 Inflation Rate Real GDP Y1 Y* AD PA AD’ Figure 2 • On the other hand, even though the recession is temporary, the government may not be too happy waiting for the economy to recover. There is good reason to believe that the horizon of the government is fairly short and that they dislike recessions. • The government can avoid a recession by pursuing expansionary fiscal policy: cuts in taxes or increases in government purchases that shift the AD curve back so that the economy does not even suffer a short-term recession. This is illustrated in Figure 2 above. III. SHOULD WE PURSUE EXPANSIONARY FISCAL POLICY IF THE ECONOMY IS AT Y*? • In the last lecture, we discussed how a cut in taxes or an increase in G will lead to a short-term boom but in fact lead to higher inflation in the long run. This is reproduced in Figure 1 below. • So we face a tradeoff: essentially long term inflation for short-term increases in output. If you had the long-term health of the economy in mind, then we should not try to pursue expansionary fiscal policy unless the economy is in a slump because it will lead to more inflation. • This conclusion depends on the assumption that Y* was unaffected: that the fiscal policy left the economy’s long run ability to produce goods and services unaffected. We know that this is not always the case. If the increased spending was on (for example) a. Improving research used to come up with new technologies. b. Programs designed to improve the education level of workers. c. Job training programs that better matched workers with jobs Then the economies long run ability to produce increases because technology and/or labor increases. • Conversely, if the increased spending was on wasteful programs that cause interest rates to increase then the resulting fall in investment can in fact REDUCE the economy’s long run ability to produce by pushing out investment. • So in short, the impact of increased G on Y* can be ambiguous. We will generally assume that it has NO effect unless I expressly say otherwise (this is because I as Supreme Dictator have the last word!). • However, let’s think about the case where the government spends money on research programs that will increase the economy’s ability to produce goods and services in the long run. The results are given below in Figure 2. • The increased spending will shift the AD curve out and also shift Y* out to *1Y (in general by less than the increase in Y). Overtime prices will rise as Y>Y* but the overall inflationary impact is smaller than in the case where Y* is unaffected. Furthermore, output will end up higher than the original level so the expansionary fiscal policy is good for the economy. Inflation Rate Real GDP Y* Y1 AD’ PA AD PA’ Figure 1