pcecon.com Class Notes
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If the government is using its spending or taxing policy to influence the national economy, it is called (in general) fiscal policy
FISCAL POLICY is government using its spending and taxing to influence the economy.
It all started in the 1930's...
The Keynesian view, named after John Maynard Keynes (pronounced "canes") is that prices, interest rates, and wages are not very flexible, especially in the down direction, so short run equilibrium may last a long time if there is a recession or depression.
However, other things can be done to return the economy to long run equilibrium. These involve moving aggregate demand (AD) rather than waiting for the self-correcting mechnism to move short run aggregate supply.
Keynes recognized that income is a big factor in spending of consumers, so getting income up is important.
Government can start by increasing some people’s income, which will multiply (the “multiplier effect”).
The government’s “autonomous” spending will increase consumers’ incomes, thus “inducing” them to spend more. Other people thus have their incomes also increased, and are induced to spend more.
Government can’t raise taxes while it increases spending, since that will undo what it is trying to do. Cutting taxes while raising government spending is even better than just raising spending.
The conclusion is that government spending helps the economy, especially if the the government runs a deficit.
tax revenues<government spending
is a deficit
tax revenues>government spending
is a surplus
tax revenues = government spending
is a balanced budget
If the economy has high unemployment (low real GDP growth) and low inflation, the way to solve the problem is to increase AD by expansionary fiscal policy (increased G spending or cuts in taxes, T).
On the other hand, if the economy has lots of inflation, we need to cut back aggregate demand by using restrictive fiscal policy, involving higher taxes and reduced government spending.
Using expansionary policy to cure recessions and using restrictive policy to cure inflation is called countercyclical policy.
These changes take time: it takes time to recognize that policy is needed, it takes time for Congress and the President to authorize spending or taxing changes, and then it takes time to actually spend the money or give the tax cuts, for example. To cut down on these "lags," the government has set up programs to do all of this automatically.
Programs that increase spending (or reduce taxes) when there is a recession and reduce spending (or increase taxes) when the economy is tending to inflation, without any action taken by the President or Congress are called...
automatic stabilizers
Why Fiscal Policy Doesn't Work in Reality
When government borrowing raises interest rates, and thus reduces private borrowing and spending, the effect is called the crowding out effect.
If any crowding out occurs, it will offset entirely or partially the effect the government is trying to accomplish with its increased spending. Aggregate Demand (AD) will not move by much, if at all, due to larger real interest rates that come with increased government spending.
Another observation:
Some economists have found evidence that when government spends without raising taxes, nothing changes.
The explanation for this is that people know that increased spending will eventually lead to higher taxes in the future (or reduce future government spending). These expectations reduce current private AD, to offset government spending. Also, interest rates don’t change, since increased government borrowing is offset by increased private saving.
The effect is called “Ricardian equivalence.” Economists who believe this is an accurate prediction are associated with
New Classical Economics
Which concludes that increased government spending and deficits are offset by private spending being reduced without interest rates going up.
To summarize the "demand side" views of fiscal policy...
Keynesian view: increased G without increase in T will increase AD
Crowding out view: increased G without increase in T will not increase AD, because of rising interest rates.
New Classical view: increased G without increase in T will not increase AD, because of anticipated future taxing and
spending changes (no interest rate effect)
Theories are fine, but remember that we are trying to be scientific. If there are no observations that line up with the theory, then the theory must be modified or discarded altogether.
There is little empirical (observational) evidence to support the Keynesian theory. Rather, in the short run, crowding out seems to occur, followed in the longer run by the predictions of the New Classical theory.
Thus, it seems that fiscal policy is of little value in changing aggregate demand in a measurable and significant way. Even if it did, the results would be in the short run only, but even those results seem not to occur.
There does seem to be one way in which fiscal policy has economic effects on such things as real GDP and economic growth, however.
These effects might be on aggregate supply rather than aggregate demand.
The Supply-side view of fiscal policy theorizes that changes in tax rates may increase aggregate supply in the long run and in the short run. The way this might work is if lowering tax rates encourages workers and other owners of resources to increase the supply of resources to the economy (especially in the long run). If this occurs, long run aggregate suppy will increase (and the short run aggregate supply with it). To sell the idea to policymakers, the supply side theorists point out that the Laffer curve says that government may make more tax revenue if tax rates are too high and are lowered, since the tax base will be increased. In other words, reducing tax rates might lead to more taxable real GDP and thus might lead to more tax revenues for the government.
Notice, the supply side theory deals with tax rates, not merely tax money The distinction is vital. Just giving people a cut in the money they pay in taxes regardless of what they do is basically a Keynesian type of tax cut. For example, in 2001, the government gave every taxpayer a $300 "tax cut" (which was basically just a gift of $300). Such a tax cut did not lower the cost of working or change the incentives of any sort of productive activity. Thus, it would only have effects on aggregate demand.
In contrast, the government lowered marginal tax rates in 2002, so that each person earning money could keep more of the pay he or she got paid. This gave each worker an incentive to work more, since he or she could keep a bigger portion of the extra money earned. This would then affect aggregate supply rather than aggregate demand.
There is some evidence supporting the supply side veiw of fiscal policy. Lowering tax rates is usually followed by increased real GDP growth, and raising tax rates is usually followed by decreased real GDP growth.
When aggregate demand is increased (throught the Keynesian deficit creation, for example), real GDP would increase while the price level (or inflation) is also increasing. If aggregate supply is increased, real GDP will be increasing, but inflation will either not change or will decrease.
Using these different expected results (different with regard to what happens to inflation), we can test whether a tax cut (for example) has effects on aggregate demand or on aggregate supply. Evidence for supply side theory exists in the last three major tax rate reductions in the U.S. economy. In each case, real GDP growth increased while inflation fell (the effects being seen for two to three years).
Supply side theory also predicts that when tax rates are raised, aggregate supply will fall. Support for this prediction is contained in the evidence that the last two times that tax rates were increased, real GDP fell (in 1991) or the growth in real GDP fell, while inflation actually increased.