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