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October 17 notes - Fiscal Policy Controversies REQUIRED...

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Unformatted text preview: Fiscal Policy Controversies REQUIRED READING CHAPTER 11, INCLUDING APPENDICES A & B What are the Important Fiscal Policy Controversies? • Activism • “Fine-Tuning” v. “Broad-Tuning” • Spending v. Tax Policies • Supply-Side Economics • Obama Stimulus Package Fiscal Policy Activism Model : Yd D( P, C , I , Ao , G, TR, TX , t ) Fiscal Instruments Ys Yd S ( P, Wo , Z o , TEo , K o ) Ys Can/Should the government use fiscal tools to counter business cycle movements or to achieve certain targets? Recession: Use Expansionary Policy 1st Step Recession: Use Expansionary Policy 2nd Step Can the government offset the reaction? Trade-offs: Expansionary Policies Social Benefit: Achieves Y^Tar (higher target level of real income) Social Cost: Higher P (or inflation) -Have to weigh costs with benefits- High Prices: Use Contractionary Policy 1st Step High Prices: Use Contractionary Policy 2nd Step Trade-offs: Contractionary Policies Social Benefit: Achieve Target Price Social Cost: Decline in real income and output (Y), which could increase unemployment Using Fiscal Policy to “Fine-Tune” the Economy Can/Should the government Concensus is no: • Problems: use activist fiscal policy to fine-tune the P or Y? Difficulty in Predicting precisely the Effects of Fiscal Policy Overshooting the target Prediction Problems: An Example • Assume Target is to Increase Y by $300 billion Government Purchase Multiplier = 2 Government decides to increase Military Spending by $150 billion • Estimates of the Multiplier are 1.5 to 2.5 • Effect on Y can then vary from $225 billion to $375 billion Can undershoot or overshoot the target. Overshooting Problems • Lags in Conduct of Fiscal Policy Implementation Lag Lag in the Effect on the Economy • Shifts in Private Spending Overshooting a Real Income Target <--- Political lag causes an overshoot from Y target because economic situation changes 1. implementation lag -political squabbling 2. Lag in conduct -Once congress decides on what action to take, the effects take time ---------> Can take a year to two years for effects to happen, in that time, things can change. Overshooting a Price Level Target “Broad-Tuning” • Use Activist Fiscal Policy to counter Serious or Big problems with the economy Deep Recession Unemployment of 7-10% or higher Use Expansionary Fiscal Policies High Price Level or High Inflation Inflation of 10-12% per year or Higher Use Contractionary Fiscal Policies Unwise for government to undertake fine-tuning fiscal policy, but okay for serious problems. Spending v. Tax Policies • Question: To achieve Targets with Fiscal Policies, should the Government use: Changes in Government Purchases? Changes in Transfer Payments? Changes in Taxes? What Are the Issues? • Key Determinant: Mainly Long-term political views on the Size of the Government • Economic Effects: Usually not critical for the Effectiveness of Fiscal Policies to counter undesirable business cycle movements -What instrument you choose to change doesn't usually matter • Political Effects: Spending changes, Tax changes, or Transfer changes can be Difficult to Eliminate once enacted Basic Conflicts Advocates of Bigger Government in US advocate: Expansionary Policies: Contractionary Policies: G or TX or TR t Advocates of Smaller Government in US advocate: Expansionary Policies: TX or t Contractionary Policies: G or TR Supply-Side Economics • Personal Tax Cuts—Designed to Increase Labor Supply • Business Tax Cuts—Designed to Increase Saving, Investment & Capital Formation Modified Aggregate Supply Curve Ys OTE , S ( P, Wo , Z o , TEo , K o , t ) t Ys Another variable that decides position of aggregate supply curve is marginal tax rate. -Lower marginal tax rates increase work effort as households try to achieve higher levels of income. Why? Because if lower marginal tax rates and raise income, can keep a bigger part of income! Can: 1) Work more hours 2) Second job 3) 2nd unemployed person in house can get job Effects on AS A Supply-Side Tax Cut: Supply-Side Effects A Supply-Side Tax Cut: Supply-Side & Demand-Side Effects Problems in Practice Effects on aggregate demand happen quickly, and aggregate supply, slowly Another Problem-Deficits Some Supply-side advocates argued that a raise tax revenues, i.e., But, in most economies, tY If taxes go down, but real income goes extraordinarily high, tax revenues might actually go up t will Will discuss more fully later t would tY and Deficits Potential Long-Run Effects ...
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