Transcript The Art and Science of Economics

Evolution of Fiscal Policy Making
Prior to the Great Depression, public policy was shaped
by the views of classical economists
Believed that free markets were the best way to achieve
national economic prosperity
Economists believed that natural market forces, such as
changes in prices, wages, and interest rates, would
correct the problems of inflation and unemployment 
no need for government intervention in the economy
Government deficit considered immoral. Thought active
fiscal policy would do harm, not good (Fed Gov’t small
player anyway – 3% vs 20% of GDP today).
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Great Depression and World War II
Long depression of 1930’s made people question
classical school of thought (economy will correct
itself)
Unemployment at 25%
1936 - Keynes, Cambridge University, “General
Theory of Employment, Interest and Money”
Keynesian theory and policy were developed to
address the problem of unemployment arising
from the Great Depression
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Keynes’s main quarrel with the classical
economists was that prices and wages did not
appear flexible enough to ensure the full
employment of resources, e.g, they were sticky
 natural forces would not return the economy
to full employment in a timely period .(Recall
our model, wages and prices must adjust to
move back to potential output)
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Great Depression and World War II
Keynes also believed business expectations might at
times become so bleak that even very low interest rates
would not spur firms to invest all that consumers might
save.
Much learned about economy through studying Great
Depression
The Great Depression continues to influence
economic thought and policy solutions
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Great Depression and World War II
Three developments following the Great Depression
bolstered the use of discretionary fiscal policy in the
United States
The influence of Keynes’s General Theory in which
he argued that natural forces would not necessarily
close a contractionary gap  government would
have to increase aggregate demand so as to boost
output and employment
The demands of World War II greatly increased
production and in the process eliminated cyclical
unemployment during the war years
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Great Depression and World War II
The third development, largely a consequence of the
first two, was the passage of the Employment Act of
1946, which gave the federal government
responsibility for promoting full employment and
price stability (prior to this time, only fiscal policy was
balanced budget)
The combined impact of these factors led policy
makers grew more receptive to the idea that fiscal
policy could improve economic stability.
Additionally, the objective of fiscal policy was no
longer to balance the budget but to promote full
employment with price stability even if deficits
occurred in the process
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From the Golden Age to Stagflation
John F. Kennedy was the first president to
propose a federal budget deficit to
stimulate an economy by proposing a tax
cut for the purpose of stimulating business
investment, consumption, and employment
Discretionary fiscal policy is a type of
demand-management policy because the
objective is to increase or decrease
aggregate demand to smooth fluctuations
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From the Golden Age to Stagflation
However, the 1970s were different when the
problem was stagflation  the double
trouble of higher inflation and higher
unemployment resulting from a decrease in
aggregate supply
Demand-management policies were ill
suited to solve these problems because an
increase in aggregate demand would worsen
inflation, whereas a decrease in aggregate
demand would worsen unemployment
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Problems with Fiscal Policy
Other concerns also caused economists and policy
makers to question the effectiveness of
discretionary fiscal policy
The difficulty of estimating the natural rate of
unemployment
The time lags involved in implementing fiscal
policy
The distinction between current and permanent
income
Possible feedback effects of fiscal policy on
aggregate supply
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Natural Rate of Unemployment
The unemployment rate that occurs when the
economy is producing its potential GDP is
called the natural rate of unemployment
Before adopting discretionary policies, public
officials must correctly estimate this natural
rate
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Lags in Fiscal Policy
The time required approving and implementing
fiscal legislation may hamper its effectiveness
and weaken discretionary fiscal policy and may
in fact do more harm than good
Since a recession is not usually identified as
such until at least six months after it begins, and
since the recessions since 1949 lasted an
average of 11 months, this leaves a narrow
window in which to execute discretionary fiscal
policy
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Permanent Income
The original belief was that given the marginal
propensity to consume, a relationship that is
among the most stable in macroeconomics, tax
changes could increase or decrease disposable
income to bring about any desired change in
consumption
A more recent view is that people base their
consumption decisions not merely on changes in
their current income but on changes in their
permanent income
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Permanent Income
Permanent income is the income a person
expects to receive on average over the long run
Thus, changes in taxes that are regarded as
temporary will not stimulate consumption and
may render fiscal policy ineffective
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Feedback Effects
Fiscal policy may unintentionally affect
aggregate supply
For example, suppose the government increases
unemployment benefits and finances these
transfer payments with higher taxes on current
workers.
If the marginal propensity to consume is the
same for both groups, the reduction in spending
by those whose taxes increase should just offset
the increase in spending by transfer recipients
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Feedback Effects
Thus, with a fiscal policy that focuses on aggregate
demand, there should be no change in aggregate
demand or on equilibrium real GDP
But what of possible effects of these changes on the
labor supply?
The unemployed, who benefit from increased transfers,
now have less incentive to find work
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Feedback Effects
Conversely, workers who find their after-tax wage
reduced by the higher tax rates may be less willing
to work
In short, the supply of labor could decrease as a
result of offsetting changes in taxes and transfers
with the result that aggregate supply would decline
 economy’s potential GDP would decline
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Budget Deficits of the 1980s and 1990s
The Reagan tax rate cut reflected a philosophy
that reductions in tax rates would make people
more willing to work and to invest because they
could keep more of what they earned
Lower taxes, would increase the supply of labor
and the supply of other resources thereby increasing
aggregate supply and the economy’s potential GDP
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Supply Side Economics
This supply-side theory held that enough
additional real GDP would be generated by the
tax cuts that total tax revenue would actually
increase
What actually happened?
Taking 1981 to 1988 as the time frame, we can
examine the effects of the 1981 federal income
tax rate cut.
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Supply Side Economics
After the tax cut was approved but before it took
effect, a recession hit the economy and the
unemployment rate increased
Between 1981 and 1988 employment climbed by 15
million and real GDP per capita increased by about
2.5% per year
The stimulus from the tax rate cut helped sustain a
continued expansion during the 1980s, the longest
peacetime expansion to that point in history
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Supply Side Economics
Despite the growth in employment,
government revenues did not expand to
offset the combination of tax cuts and
increased government spending
Between 1981 and 1988, federal outlays
grew an average of 7.1% while federal
revenues averaged a 6.3% increase  the
deficits accumulated into a huge national
debt which doubled relative to GDP from
33% in 1981 to 64% in 1992
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Political Business Cycles
William Nordhaus developed a theory of
political business cycles, arguing that
incumbent presidents use expansionary
policies to stimulate the economy, often only
temporarily, during an election year
That is, they try to increase their chances of
reelection by pursuing policies that stimulate
real GDP and reduce unemployment
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Political Business Cycles
The evidence to support the theory of
political business cycles is not entirely
convincing
One problem is that the theory limits
presidential motives to reelection, when in
fact presidents may have other objectives
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Political Business Cycles
An alternative to this theory, and one that is
supported by some evidence, is that
Democrats care relatively more about
unemployment and relatively less about
inflation than do Republicans
Democrats tend to pursue expansionary
policies while Republicans tend to pursue
contractionary policies
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Balancing the Budget
The combination of increased taxes imposed
by the Clinton administration and a vigorous
recovery fueled by growing consumer
spending, rising business optimism, and the
strongest stock market in history led to
record budget surpluses
However, by early 2001, U.S. economic
growth was slowing, so that President George
W. Bush pushed through across the board tax
cuts
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Balancing the Budget
The terrorist attack on September 11, 2001
further depressed consumer confidence with
the result that taxpayers spent only about onefifth of the tax rebate checks
Thus, additional stimulus programs were put
in place
Leading to current recovery
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