Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

26
Aggregate Demand Policy in Perspective Problems with Fiscal Policy

Transcript of Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Page 1: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Aggregate Demand Policy in Perspective

Problems with Fiscal Policy

Page 2: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

5. When you get drunk, you can tell everyone that you are just researching the law of diminishing marginal utility.

Laugher Curve

• Top Five Reasons to Study Economics

Page 3: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

4. You can talk about money without having to make any.

Laugher Curve

• Top Five Reasons to Study Economics

3. You can say “trickle down” with a straight face.

Page 4: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

2. When you are in the unemployment line, at least you know why you are there.

Laugher Curve

• Top Five Reasons to Study Economics

1. If you rearrange the letters in ECONOMICS, you get COMIC NOSE.

Page 5: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Supply Side versus Demand Side Policies• The interrelationship between AS and AD is captured in the circular flow diagram.

• AS (production by firms) creates output and income, and hence AD (the potential demand to buy that output.

Page 6: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Supply Side versus Demand Side Policies• The AS/AD model separates long-run

aggregate supply from short-run aggregate demand forces.

– Demand-side policies (monetary and fiscal policy) shift the AD curve.

– Supply-side policies work by increasing potential output.

Page 7: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Supply Side versus Demand Side Policies• Politicians are not constrained by

models.

• They can, and do, often emphasize different interconnections.

Page 8: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Real output

Pric

e Le

vel

Demand-Side and Supply-Side Policies

YP

LAS

AD

Supply-side policies shift the LAS curve.

SAS

Demand-side policies (monetary and fiscal policies) shift the AD curve

Page 9: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Problems with Fiscal Policy

• Six assumptions of the AS/AD model lead to problems with fiscal policy:– Financing the deficit has no offsetting effects.– The government knows what the situation is.– The government knows potential income.– The government has flexibility in changing

spending and taxes.– The size of the government debt doesn’t matter.– Fiscal policy doesn’t negatively affect other goals.

Page 10: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Financing the Deficit Doesn’t Have Offsetting Effects• Some economists believe that

government financing of deficit spending offsets the deficit’s expansionary effect.

• They believe that government borrowing increases interest rates and crowds out private investment.

Page 11: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Financing the Deficit Doesn’t Have Offsetting Effects• Crowding out – the offsetting of a

change in government expenditures by a change in private expenditures in the opposite direction.

Page 12: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Financing the Deficit Doesn’t Have Offsetting Effects• Some economists argue that the effect

of government expenditures is negative.

• They consider private spending to be more productive than government spending.

Page 13: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Financing the Deficit Doesn’t Have Offsetting Effects• Crowding out also works in reverse in

contractionary fiscal policy.

– When the government runs a surplus, it buys back bonds.

– Interest rates will drop, stimulating investment.

Page 14: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Real output

Pric

e Le

vel

Partial Crowding Out

Y0 Y2 Y1

AD0 AD2 AD1

Partial crowding outNet effect

SAS

Page 15: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Knowing What the Situation Is• Data problems limit the use of fiscal

policy for fine tuning.

• Getting reliable numbers on the economy takes time.

• We may be in the middle of a recession and not know it.

Page 16: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Knowing What the Situation Is• The government has large econometric

models and leading indicators to predict where the economy will be in the near future.

• Economic forecasting is still very much an art and not a science.

Page 17: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Knowing the Level of Potential Income• No one knows for sure the level of

potential income.

• Potential income has been called the full-employment level of income.

Page 18: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Knowing the Level of Potential Income• Differences in estimates of potential

income often lead to different policy recommendations.

Page 19: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Knowing the Level of Potential Income• In most cases, the U.S. economy is in

an ambiguous state.• Some economists will call for expansionary

policy and others call for contractionary policy.

Page 20: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

The Government’s Flexibility in Changing Taxes and Spending• Putting fiscal policy into place takes

time and has serious implementation problems.

• Numerous political and institutional realities in the U.S. today make it a difficult task to implement fiscal policy.

Page 21: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

The Government’s Flexibility in Changing Taxes and Spending• Squabbles between Congress and the

President may delay implementing appropriate fiscal policy for months, even years.

Page 22: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Size of the Government Debt Doesn’t Matter• These is no inherent reason why the

adoption of activists policies should have caused high government deficits year after year.

Page 23: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Size of the Government Debt Doesn’t Matter• Activist policy has led to an increase in

government debt because:

– Early activists favored large increases in government spending as well as favoring the government's using fiscal policy.

– Politically, it is much easier for government to increase spending and decrease taxes than vice versa.

Page 24: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Size of the Government Debt Doesn’t Matter• If one believes that debt is harmful,

then there might be a reason not to conduct expansionary fiscal policy, even when the model calls for it.

Page 25: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Fiscal Policy Doesn’t Negatively Affect Other Government Goals• An economy has many goals –

achieving potential income is only one of those goals

• National economic goals often conflict.

Page 26: Aggregate Demand Policy in Perspective Problems with Fiscal Policy.

Summary of the Problems

• While the six problems listed above do not necessarily eliminate fiscal policy altogether, they severely restrict it.

• Fiscal policy is a sledgehammer, not an instrument for fine-tuning.