Ranjit Dighe
WEEK 12 (LECTURES 30-32)
Nov. 15-19, 1999

[This week's notes are on fiscal policy and correspond to Chapter 12 of McConnell's textbook.  They were last revised on Thurs., Dec. 2, at 4:30 pm.]

Mon., Nov. 15, 1999

* Today: Fiscal policy (begin)


Here are a few examples of real-life economic policy decisions:
* In the early 1980s, the economy was slumping, and Congress in 1981, in response, voted to cut tax rates by 25%. Many Congressman said they voted for the tax cut because "we had to do something" to get the economy moving again.
* In the late 1960s, during the Vietnam War boom, Congress imposed a 10% tax increase ("tax surcharge") on corporate and personal incomes. The purpose was to rein in private spending (AD) and the associated demand-pull inflation, which by then had started to accelerate.
* In the 1990s, Japan's economy has been in a decade-long slump, and the Japanese government has responded by repeatedly increasing its spending and cutting taxes to boost aggregate demand.

--> Common thread: The government often uses its spending and taxing decisions in order to influence the state of the economy.

Def. FISCAL POLICY-- the spending and taxing policies used by the government to influence the economy.
-- Fiscal policy can be complex (since there are many different taxes and many different spending programs, and they have different multipliers associated with them), but for now we will focus on changes in the absolute levels of government purchases (G) and tax revenues (T).

G = purchases of goods & services by the government (federal, state, & local). Note: does not include transfer payments (Social Security, welfare), interest payments on the national debt (to government bond holders), or subsidies.

T = total tax receipts (to be precise, T stands for net taxes, which are tax revenues minus transfer payments and subsidies).

-->  G - T is the government's budget deficit. If G - T > 0, deficit; if G - T < 0, surplus.
       T - G is the government's budget surplus.

Of the government's two main tools for managing the economy, fiscal policy and monetary policy, Keynes and early Keynesians (economists who generally agreed with Keynes's ideas) emphasized fiscal policy.

Fiscal policy can be either EXPANSIONARY or CONTRACTIONARY.

(1) EXPANSIONARY FISCAL POLICY occurs when the government deliberately increases its deficit in order to stimulate the economy.
-- In expansionary fiscal policy, the government increases its spending (G) or cuts taxes (T) or both.
-- Expansionary fiscal policy stimulates the economy because it increases aggregate demand (AD).
-- When the government increases G, it adds directly to AD, since G is part of AD (= C+Ip+G+Xnet).
-- When the government cuts T, it increases people's disposable income (total income minus taxes), and people will spend much of that extra income, so consumption (C) increases.
-- In both cases, AD will also increase indirectly through the multiplier effect, as the initial increase in G or C touches off a whole chain of consumption.
-- In both cases, real GDP will increase and so will the price level. Expansionary fiscal policy (or a fiscal expansion) means the economy is moving northwest along the Phillips Curve, to a point of lower unemployment and higher inflation. (This is an example of demand-pull inflation.) Or, in terms of the AD-AS model, the AD curve shifts out, causing equilibrium real GDP (Q) to increase and the equilibrium price level (P) to increase.
-- [See Figure 11-8(c) on page 235 of McConnell's book for the relevant AD-AS diagram. This would be a good thing to know for the exam.]

(2) CONTRACTIONARY FISCAL POLICY occurs when the government deliberately reduces its deficit in order to slow down the economy (usually with the goal of reducing inflation).
-- In contractionary fiscal policy, the government cuts its spending (G) or raises taxes (T) or both.
-- Contractionary fiscal policy contracts the economy because it decreases AD.
-- The net effect of contractionary fiscal policy, all other things equal, is to induce a recession or at least slow down the rate of growth of the economy. A fiscal contraction would cause the economy to move southeast along the Phillips Curve, to a point of higher unemployment and lower inflation. Applying the AD-AS model, a fiscal contraction causes the AD curve to shift inward; as a result, equilibrium Q decreases and equilibrium P decreases.
-- [The relevant AD-AS diagram would be the opposite of Figure 11-8(c), with the AD curve shifting in instead of out.]


When the government increases G, the people whom it pays for those extra goods and services now have higher incomes, and they will spend some of that extra income (consumption increases), touching off a whole chain of consumption (C). The ultimate, cumulative increase in AD will be a multiple of the original increase in G.

When the government cuts taxes, people spend their extra after-tax income, and that initial increase in consumption leads to more consumption, by the people who sell the goods or services in each round of consumption. Again, because of the multiplier effect, the ultimate increase in AD (which is entirely an increase in C in this case) will be a multiple of the original tax cut.

When we draw the AD shifts that result from a fiscal policy change on AD-AS diagrams, we draw just one big shift which corresponds to both the initial change in AD (e.g., the increase in G or the initial increase in C from the tax cut) and the subsequent change in AD (which arises from the multiplier effect). We can think of there being one AD shift for every step of the multiplier process, but that would be an awful lot of AD shifts to draw.

-- Ex.: If the multiplier is 4 and G is cut by $5 billion, then the initial AD shift would be a horizontal leftward shift of $5 billion and the cumulative AD shift (which is the one we draw) is a horizontal leftward shift of $20 billion (4 * $5 billion).
---- [See Figure 12-2 on page 246 of McConnell's book for an illustration of this example.]

Combining this notion of fiscal policy changes as AD shifts with the fact that the economy is normally on the upward-sloping part of the AS curve, then we should note that a given increase in AD will cause a somewhat smaller increase in equilibrium real GDP than the simple multiplier model would indicate. What happens is that, as with any other increase in AD, some of the supply response comes in the form of a higher quantity supplied and some comes in the form of higher prices. If the economy were on the flat (horizontal) part of the AS curve, the increase in AD and the increase in Q would be the same.

Putting aside that important fact, however, and assuming for simplicity's sake that the economy is on the flat part of the AS curve, the government spending multiplier is the same as the regular multiplier:

{spending multiplier} = 1 / (1-MPC),
because G is a component of autonomous spending.
-- If MPC = 0.8, then the government spending multiplier is 5 (= 1/(1-0.8)).

The multiplier associated with a given change in taxes, the tax multiplier, is negative, because higher taxes reduce people's disposable income, thereby reducing their consumption. The tax multiplier is smaller (in absolute value) than the spending multiplier because not all of a tax increase represents income that otherwise would have been consumed -- the marginal propensity to consume is less than 1, so some fraction of every dollar gets saved, which does not add to aggregate demand or GDP. The initial change in consumption associated with a $1 tax increase is

- MPC * ($1) = -MPC.
That amount is the change in autonomous spending that results from a $1 tax increase, and we multiply it by the regular multiplier to get:
{tax multiplier} = - MPC / (1-MPC)
-- If MPC = 0.8, then the tax multiplier is -4 (= -0.8/(1-0.8) = -0.8/0.2 = -8/2).

For next time: Think about what would happen if the government increased spending and taxes by equal amounts, applying these multipliers. The result may surprise you.


Wed., Nov. 17, 1999


* Today: Fiscal policy (continued):
I.    Spending, tax, and balanced-budget multipliers
II.  The deficit's influence on the economy



Where we left off: What if the government increased spending (G) and taxes (T) by equal amounts (say, $100 billion more of each)? For most of us, our automatic response is to think that would somehow be a bad thing for the level of GDP, since higher taxes plainly lower our disposable incomes and leave less for our consumption. Or we might think that it would have zero effect on GDP, because the higher spending and the higher taxes would seem to offset each other. But, in the context of the multiplier model, both of those guesses would be wrong. Instead, an equal increase in G and T would actually raise GDP, in the context of the multiplier model.
-- Why: returning to what we did last time with the spending and tax multipliers, recall that the government-spending multiplier is

{spending multiplier} = 1 / (1-MPC),
and the tax multiplier is
{tax multiplier} = - MPC / (1-MPC).
-- Add the two together and you get the multiplier for an equal increase in government spending and taxes. Equivalently, it is the increase in equilibrium GDP that results from a $1 increase in G and a $1 increase in T. We call it the BALANCED-BUDGET MULTIPLIER (BBM; or perhaps more accurately the tax-and-spend multiplier), and it is equal to the sum of those other two:
                           {BBM} = 1/(1-MPC) - MPC/(1-MPC)
                                         = (1-MPC) / (1-MPC)            (combining the two terms, which have a common denominator)
                                         = 1

So the balanced-budget multiplier is 1, meaning that a given increase in G (say, $1 million) coupled with an equal increase in T ($1 million) would raise equilibrium GDP by that same amount ($1 million).
-- We call it the balanced-budget multiplier because an equal increase in G and T would not change, let alone increase, the government's budget deficit. If the budget were balanced to begin with (a deficit of $0), it would still be balanced after an equal increase in G and T.
---- (The term balanced-budget multiplier does not necessarily mean that the overall budget is in balance, just that we're increasing G and T by equal amounts.)

-- This is a startling result. Having grown up in a conservative era in which politicians of both parties say they're against "big government" and talk about how they want to cut government spending, it's easy to forget that government spending, even when it's wasteful, is counted in GDP provides incomes for the people from whom the government is purchasing goods and services. This, by the way, is why many political conservatives hate Keynes, since Keynes originated the concept of the multiplier, including the balanced-budget multiplier.

-- Why the balanced-budget multiplier is positive: The spending multiplier is larger than the tax multiplier, because some fraction of any dollar of income that is taxed would have been saved instead of consumed, and savings do not contribute to GDP. (That fraction, by the way, is the marginal propensity to save, and is estimated as .05 for the United States today.)

Technical note: In these multiplier examples we've seen so far, the type of tax we've considered is a LUMP-SUM TAX, which is a tax that is a fixed dollar amount that does not depend on income or consumption or anything else in the multiplier model. If the U.S. government were to impose a lump-sum tax of $100 on everyone, then every person, rich or poor, would pay the same amount, $100. This obviously isn't the way most taxes work, but it makes the math in these models way, way easier.
-- So if in an example we assume that T equals, say, $500, that means there is a lump-sum tax of $500 (to be precise, $500 total, since all of the variables in the multiplier model -- C, I, G, X, M, Q, S -- are totals for the whole economy.)

A three-part example

Let us compare the different equilibrium levels of GDP for the same economy (1) with no government spending or taxes, (2) with government spending but no taxes, and (3) with equal amounts of government spending and taxes. Consumption, planned investment, and net exports in this economy are:

C = 500 + 0.95*DI (DI = disposable income = Q - T)
Ip = 500
X = M = Xnet = 0

(1) If G=T=0, then the economy is:

     C = 500 + 0.95*DI = 500 + 0.95*(Q-0) = 500 + 0.95Q
     Ip = 500
     G = 0
     Xnet = 0

Solving with our favorite shortcut ([i] find total autonomous spending, Cautonomous + Ip + G + Xnet, [ii] find the multiplier, 1/(1-MPC), and then [iii] multiply them together to get equilibrium GDP (Qequil.):

     (i) {autonomous spending} = Cautonomous + Ip + G + Xnet = 500 + 500 + 0 + 0 = 1000
     (ii) {multiplier} = 1/(1-MPC) = 1/(1-.95) = 1/.05 = 20
     (iii) Qequil. = {autonomous spending} * {multiplier} = 1000 * 20 = 20,000

(2) Now assume that the government spends $100 but collects no taxes. With a multiplier of 20, we can already conclude that equilibrium GDP will be $2000 [=20*$100] higher than before and hence will be $22,000, but let's do it the long way. The economy is now:

     C = 500 + 0.95*DI = 500 + 0.95*(Q-0) = 500 + 0.95Q
     Ip = 500
     G = 100
     Xnet = 0

Solving for Qequil.:

     (i) {autonomous spending} = Cautonomous + Ip + G + Xnet = 500 + 500 + 100 + 0 = 1100
     (ii) {multiplier} = 1/(1-MPC) = 1/(1-.95) = 1/.05 = 20
     (iii) Qequil. = {autonomous spending} * {multiplier} = 1100 * 20 = 22,000

Note that the increased government spending (G increased from $0 to $100) has caused GDP to increase by 20 times that amount. The government-spending multiplier here is 20.

(3) Now assume the government spends $100 and collects $100 in lump-sum taxes. (Note: its deficit, G-T, is $0.) The economy is now:

     C = 500 + 0.95*DI = 500 + 0.95*(Q-100) = 500 + 0.95Q - 95 = 405 + 0.95Q
     Ip = 500
     G = 100
     Xnet = 0

Solving for Qequil.:

     (i) {autonomous spending} = Cautonomous + Ip + G + Xnet = 405 + 500 + 100 + 0 = 1005
     (ii) {multiplier} = 1/(1-MPC) = 1/(1-.95) = 1/.05 = 20
     (iii) Qequil. = {autonomous spending} * {multiplier} = 1100 * 20 = 20,100

Comparing the results of (1) and (3), we see that equilibrium GDP is $100 higher ($20,100) when the government taxes and spends $100 than when government spending and taxes were both zero (equilibrium GDP was $20,000).
-- Another notable result is that despite the higher taxes in (3) as compared to (1), private consumption is the same in both cases. To verify, equilibrium consumption is:
---- in case (1): Cequil. = 500 + 0.95*Qequil. = 500 + 0.95*20000 = 500 + 19000 = 19,500
---- in case (2): Cequil. = 405 + 0.95*Qequil. = 405 + 0.95*20100 = 405 + 19095 = 19,500
---- While the tax increase on its own would have hurt consumption and GDP, the equal spending increase, through its larger multiplier effect, raises GDP and leaves consumption unchanged. Society is better off in the sense that consumption has not fallen and now there are $100 in extra government services.


In simple multiplier models, like the ones we just did, the deficit helps the economy and doesn't hurt it at all. In such models, the bigger the deficit the better, because it will increase equilibrium GDP.
-- There is no "limit" to GDP (no concept of "potential GDP" or "capacity GDP") in the multiplier model.

Q: So, then, why not have as big a deficit as possible? Eliminate all taxes. Let every Congressperson's request for greater spending for his or her district be granted, so that the government spends as much money as it could ever imagine.
-- First off, the multiplier model applies to a depressed economy, operating on the flat part of the AS curve; if we're only looking at a range of low values of GDP, then we're so far away from potential GDP that we don't need to worry about pushing the economy beyond its sustainable limit. But bigger and bigger deficits would eventually increase GDP to the point where it reached the intermediate part of the AS curve, at which point larger deficits become inflationary.
---- Once real GDP (Q) reaches potential GDP (Q*), larger deficits cause not just increased inflation but also accelerating inflation.
-- There are additional reasons, to be given in the next lecture, why government deficits are not entirely a blessing.

In simple multiplier models, the government-spending multiplier, as 1/(1-MPC), is huge, and the tax and balanced-budget multipliers are also very large. Plugging in the estimated MPC for the U.S. today, which is .95, the multiplier would be 20 (=1/(1-.95)=1/.05). The tax multiplier would be -19 (= -.95/(1-.95) = -.95/.05 = -95/5), and the balanced-budget multiplier would be 1.
-- In the real world, however, those multipliers are a lot smaller. The spending multiplier is about 1.4, the tax multiplier is about -1.3, and the balanced-budget multiplier is about 0.1, even though the U.S. MPC, as noted, is about .95.
Why the real-world multipliers are so much smaller than the ones in the model: in real life,
there are several LEAKAGES from that whole chain of consumption that drives the multiplier process, namely:
(1) taxes on incomes and sales, which mean that some fraction of every dollar spent goes not to the person selling the good or service but to the government.
(2) imports - some of every extra dollar of consumer spending is spent on imported goods instead of U.S.-produced goods, and imports are subtracted from GDP. Also, the money spent on imports is mostly re-spent in the foreign country that produced the import, not in the U.S.
(3) inflation - instead of passively responding to the increased product demand by simply supplying more goods at the same price as before, many producers will respond (and maximize their profits) by raising their prices. Those higher prices mean inflation, and the increase in real GDP will therefore be smaller than the increase in nominal GDP.
(4) higher interest rates as a result of the extra aggregate demand. Some of that extra consumption spending is on expensive durable goods, like cars and dishwashers, that are normally financed through consumer loans. Increased demand for durable goods means increased demand for loans, and the equilibrium interest rate will increase, thereby crowding out some of that durable-goods consumption and also crowding out some investment.
---- [I forgot to mention this 4th factor in Wednesday's lecture, but it is important.]

We should also note that when these multipliers are so small (1.4 for spending, -1.3 for taxes, 0.1 for BBM), the impact of any change in G or T on equilibrium GDP is easily offset by a change in monetary policy, such as a raising or lower of interest rates, by the Federal Reserve. Monetary policy is what we'll be covering after this week.


Fri., Nov. 19, 1999


* Today: Fiscal policy (lecture 3 of 4)

* Remember: This class will not meet next Mon., Nov. 22.
-- [I handed out makeup lecture notes for that day when we got back on Mon., Nov. 29. Those notes included: Measuring the national debt; The economy's influence on the deficit; Fiscal history, 1789-1980; Supply-side economics. Those makeup notes will not be posted on the web; if you didn't get a copy, I do have a few extras.]



Q: What does it mean to say, "The government is running a deficit?"
A: spending more than it takes in.
-- Is the U.S. government a deadbeat? Is it unable to pay its bills? (No-- it can easily borrow enough to cover its deficit.)

Defn. Budget deficit: the difference between what a government spends and what it collects in revenues in a given period
-- roughly, G - T
-- more precisely, all expenditures, incl. transfers & int. on debt minus all revenues, incl. tariffs & user fees).
-- currently is negative, because the government is running a surplus; deficit = - $123 billion, ~ -1.4% of GDP

How does the government pay for its deficit? Options:

1. money financing: could print money (or have the Federal Reserve buy bonds directly from Treasury and pay for them by creating money)
-- This is called "monetizing" the debt, or the "inflation tax," because it tends to be extremely inflationary and has been the source of most hyperinflations.
-- It is most common in 3rd World countries.

2. debt financing: sell bonds -- what U.S. does, mainly (bonds=debt)
-- When bonds mature, government must pay interest plus principal (original amount borrowed)
   --> When that happens, the government's typically raises the money to make those payments by selling more bonds.
---------- This is somewhat again to a classic scam known as a "Ponzi game" or "Ponzi scheme."  The difference is that the government is doing all of this openly, and as long as people have confidence in the government's ability to repay its debts, the government can keep on rolling over its debt in this manner.)

Defn. National debt (federal debt): ~ The total of all accumulated federal deficits minus surpluses over time, or the total amt of U.S. government bonds outstanding.
-- currently ~ $3.6 trillion, ~39% of GDP (1999)
-- other countries' national debt: Japan, Germany-- slightly smaller as % of GDP; Great Britain-- slightly larger; Italy-- over 100% of GDP!

History: the U.S. has had a national debt since George Washington's time. (Alexander Hamilton, the first Secretary of the Treasury, thought it would strengthen and unify the country by giving wealthy bondholders a stake in seeing the government survive.) We touched "fiscal bedrock" in 1835, when A. Jackson was president, thanks to revenues from tariffs and public land sales.

Problems with deficits in the real world:

(1) In real world, a deficit typically leads to higher interest rates; partial crowding-out of investment
-- CROWDING OUT OF INVESTMENT refers to the tendency for larger government budget deficits to cause investment (and durable-goods consumption, which is also interest-sensitive) to decrease somewhat.  If the crowding out is complete, then investment and durable-goods consumption fall by exactly the same amount by which the deficit increases, and the deficit fails to increase real GDP at all.  In the real world, crowding out exists but is less than one-for-one -- an increase in the deficit of, say, $50 billion, might cause investment and durable-goods consumption to fall by $10-20 billion, but not by the full $50 billion.
---- How crowding out works:
       The government must finance its larger deficits by selling Treasury bonds
       --> To get people to buy more of those bonds, it has to offer a higher interest rate than it did before.
       --> The higher interest rate on Treasury bonds cause interest rates to go up on other bonds and on bank loans
             (because more people buying Treasury bonds drains the supply of savings that could be loaned out to corporations
              and households), and because the cost of borrowing is higher,
       --> fewer firms will borrow money for new capital investment.
-- In the simple multiplier model, by contrast, Ip is fixed; no "crowding out" effect; could even have "crowding in," if there's a marginal propensity to invest

(2) Government finances its deficits by borrowing (selling bonds -- national debt), must pay interest on that debt
---> obligation that must be met in future
-- interest on the national debt = $200 billion per year (in every year since 1992. Was only $43 billion in 1979, broke $100 billion in 1984, $150 billion in 1988.)
-- McConnell & Brue's textbook (p. 392, "Shifting Burdens" section) takes issue with this, calling it a popular misconception, because "we owe it to ourselves." They say that higher taxes and spending cuts to pay for interest on the debt are exactly offset by interest payments to American bondholders. They miss two key point, though: (1) Much of the debt is held by foreigners -- 23%, according to their own chart, on p. 391. (2) The (rich) Americans who receive T-bond interest are not exactly the same people who pay the taxes or whose spending programs are cut to pay for that interest.
-- Keynes, Mr. Fiscal Policy himself, thought budget should be balanced "over the business cycle"-- run deficits during depressions, surpluses during booms

(3) Large deficits may be inflationary -- they stimulate aggregate demand (AD curve shifts out, causing demand-pull inflation); also, the government may try to finance its deficit by printing money to pay its debts (monetizing the debt; the U.S. doesn't do this, but many countries do, and it can lead to hyperinflation).

(4) Political: raises questions about the size of government. (Big deficits allow the government to spend more money. If you're a conservative Republican and want government spending to be as low as possible, then you might dislike deficits for that reason.)