Notes 11: Fiscal Policy - Government Spending and Taxes
This set of notes is designed to put our model to work by looking at the role of government spending and
taxes in the economy.
SPENDING
Example 1: Assume we are initially in a situation of long run equilibrium (economy is in equilibrium at
Y*). Suppose the Government (Congress and the President) decreases government spending (G) and there
is no effect on the PVLR of consumers. As we saw throughout the class, changing G does not affect
PVLR. Analyze the new short term and long term dynamics of the economy. I am going to assume the
AS curve is upward sloping in the short run. Remember, with an upward AS curve - prices are allowed to
adjust, but nominal wages are fixed!
1) G falls:
A)
Does this affect the labor market in terms of labor demand or labor supply? The answer is a
resounding NO!
B)
Does this affect the AD and the IS curve? Of course! A decrease in G decreases the demand for
goods (Y = C + I + G + NX). If G decreases, demand for Y should decrease.
Let us look at this graphically: I am going to start in the AS – AD market.
AS0
P
P0
(c)
(a)
P1
(b)
AD0(G0)
AD1(G1)
Yp
Y1
Y*0
Y
The economy is initially in equilibrium at point (a). As the AD curve shifts in (due to lower government
spending), prices should fall (from P 0 to P1) AND equilibrium level of output should fall to Y 1 – which I
refer to as the equilibrium GDP in the short run. The new short run equilibrium is at (b).
Note: P0 is the initial price level in the economy. Suppose, prices were fixed in the economy and we had a
horizontal SRAS curve (i.e., prices did not change in the short run). In this case, if prices were fixed at P 0,
the leftward shift of the AD curve would result in the economy ending up at point (c) (where output is
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equal to Yp (the output level which would have occurred if prices where fixed)). The fall in GDP would
be bigger (from a given change in AD) if prices were fixed than if firms were allowed to adjust prices
(point b versus c).
Why is that?
If firms lower prices with a negative demand shock (which we assume they do in this
example), then the lower prices will increase real money balances (think about it, the denominator in M/P
decreases which causes M/P to increase). An increase in M/P increases the real supply of money, shifting
out the LM curve. This will cause real interest rates (r) to fall. Lower r will cause firms to undertake new
investment (I). GDP does not fall as much when prices are allowed to adjust because the change in prices
will cause interest rates to fall further and spur on some new additional investment (as we will see in a
second, even if prices are fixed, interest rates will fall!). So, the fall in G is offset by an additional increase
in I when prices adjust! Firms adjusting their prices will dampen the effect of recessions! If prices are
‘sticky’ in the economy, recessions will be more severe (larger decreases in Y). <<Regardless of whether
prices are fixed in the short run, we assume nominal wages are always fixed in the short run>>. Let’s look
at the IS-LM market to see the effects on interest rates and investment!
LM0 (P0)
r
LM1(P1)
G falls
r0
(d)
(a)
(c)
(b)
P falls
IS0 (G2)
IS1 (G1)
Yp
Y1
Y*0
Y
Like in the AS-AD market, a fall in G will shift in the goods demand curve. Remember, the IS curve
represents the goods side of the market Y = C + I + G + NX just like the aggregate demand (AD) curve. As
G, decreases the IS curve (and the AD curve – they are both the same – just drawn in different spaces) will
fall. This causes interest rates to fall (as does output). A lower level of output will decrease the demand
for money (we need less money in the economy because there is less stuff to buy). The lower money
demand will drive down interest rates (this is represented as point (c) on the above graph). The lower
interest rates will spur on investment. If interest rates did not fall because of the fall in the demand for
money, the fall in GDP would be a lot more severe (we would move to point (d) - the point where interest
rates are fixed!). But, as interest rates fall as output falls (due to lower money demand), investment will
pick up and offset some of the fall in output. This causes us to move to point (c). If prices were fixed, that
would be the end of the story in the short run. We would end up at point (c) in the economy (same point
(c) from AD-AS graph).
In our model, we are allowing firms to adjust prices. The lower prices due to lower demand for goods will
increase real money balances and shift out the LM curve slightly. This will lower interest rates a little bit
further and spur on some ADDITIONAL investment so output will not fall quite as far as it would if prices
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were fixed. We know from the AS-AD graph that output will definitely fall, just not as much because
prices increase real money supply.
The two shifts together – the fall in the IS and the increase in the LM will create a new equilibrium at
point (b) with output equal to Y1. Remember, there are no new shifts! As interest rates fall, investment
will increase. This, however, will not shift any of the curves. The change in investment as interest rates
change is represented by the slope of the curves!
So, interest rates will fall (and investment will rise) for two reasons:
1. As G falls, Y will fall and the demand for money will fall (this is balanced with the fact that lower G
implies less government borrowing and/or more government savings - lowering the price of savings - this is
the IS-LM analysis).
2.As P falls, M/P rises. Real money increases, which further reduces interest rates.
Both of these cause I to increase. If I did not respond, the economy would move from (a) to (d). If prices
were fixed (no effect on real money supply), the economy would move from (a) to (c). With prices allowed
to adjust, you get an extra kick to investment. In this case, output only falls from (a) to (b). This is
subtle!!!! Try hard to understand what role changing prices and changing output has on investment.
Let us, one last time, think about labor market in the short run:
There will be no shifts in the labor supply or labor demand curves. Remember - we are not in equilibrium
(we may not be on either the labor supply or the labor demand curves). As a rule (see the notes from
Thursday), all we know about N in the short run is that if Y < Y*, N will be less than N*.
Here is one graphical representation of labor market in short run.
NS
(a)
W/P
Nd
(b)
N1
N*0
N
Summarizing the Short Run Effects of a fall in government spending.
Y falls, P falls, r falls, G falls, I increases (but by a smaller amount then G falls – we know in the end that
output falls), NX and C stay the same, real wages rise in the short term (nominal wages are fixed and prices
fall), national savings increases (I increases and NX stays the same). Cyclical unemployment rises; we are
in a recession!
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What happens in the long run?
NS
(b)
(a) = (z)
W/P
Nd
N1
N*0 = N*1
N
There is no effect of changing G on labor supply or labor demand! A and K do not change so labor
demand (Nd) does not change. PVLR, taxes, population or the value of leisure do not change so labor
supply (NS) does not change. So, N*0 = N*1. The new equilibrium in the economy is (z) which is the
same as (a) - which was the old equilibrium.
In the short run, N < N*. How do we get back to N* (and Y*)? Here is where some fun begins. We
stated in class (and above) when N > N*, workers will put pressure on firms to increase wages. Nominal
wages will increase. Here we have N < N*. In this case, firms will want to CUT nominal wages. As we
talked about early in the class, firms may not like to cut nominal wages.
The process of wages adjusting to restore the economy to its long run level is often called the selfcorrecting mechanism. This is an important concept for you to understand for our next quizzes and the
final exam. The self-correcting mechanism refers to the fact that when the labor market is in
disequilibrium, it will eventually correct itself causing nominal wages to rise or fall. When N > N*, we
tend to believe that the economy will correct itself quickly. If you ask workers to work harder than their
wage says they should, workers will generally respond quickly.
The reverse is not true-- Firms will be hesitant to cut nominal wages (money illusion). As a result, we may
tend to stay in recessions longer than we would stay above Y* (From now on, I will define a recession as
being when Y is below Y* - this is slightly different than the technical definition.). Now you may say
‘Erik, we saw in Topic 1 that recessions in duration only average 1 year and expansions average 6-8 years.
Isn’t that inconsistent with the fact that you just said that recessions should last longer because the selfcorrecting mechanism will work slower because firms do not want to cut nominal wages?’ My answer to
that would be NO. Why? Because policy makers will often come in and help us get out of a recession.
This will tend to make recessions short lived (we don’t rely on the self-correcting mechanism to bring us
back to Y*. We will do an example of this soon.).
How do firms cut nominal wages?
Well, some firms will suck it up and just cut them. Others will wait for some workers to quit or retire and
bring in new workers at lower wages.
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Eventually, nominal wages will fall. Nominal wages are fixed in the short run (that got us to point (b)). In
the long run, they can adjust. The fall in nominal wages makes production cheaper which will shift out the
SRAS curve. If production is cheaper, firms want to produce more at every given price!
AS0(W0)
P
AS1(W1)
P0
(c)
(a)
P1
(b)
P2
(z)
AD0(G0)
AD1(G1)
Ysr
Y*1 = Y*0
Y
Equilibrium is restored at Y* at point (z) which has lower prices than where we started (point (a)). So, in
the long run, a fall in G will have no affect on output, but will result in lower prices. Prices will fall further
between (b) - the short run equilibrium and (z) the long run equilibrium.
What happens to interest rates?
LM0 (P0)
r
LM1 (P1)
LM2 (P2)
(a)
(c)
(b)
(z)
P falls
IS0 (G0)
IS1 (G1)
Y1
Y*1 = Y*0
Y
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As prices fall further, the real money supply will increase, causing interest rates to fall further. The LM
curve will shift from LM1 to LM2 as prices fall from P1 to P2.
In this case, investment will increase even further between the short run and the long run, restoring Y to its
original level. Now, the change in investment will EXACTLY offset the change in government spending
(G). How do we know? Y is back to its initial level – no change in Y!!! If G goes down by $100 and there
is no change in consumption and NX, then I must rise by $100! (in the long run).
It is just that simple!
Let us summarize our short run and long run results of a decrease in G with time paths (this is how
variables (like GDP) evolve over time):
Today (time 0)
Short Run
Long Run
Y
P
r
G
I
W
W/P
M/P
How should you read these time paths? Basically, time paths tell us how the variables move over time.
For example, output falls between now and the short run and then increases between the short run and the
long run. However, between now and the long run, output does not change (real wages also return to their
initial level). Nominal wages are fixed in the short run. Government spending (G) decreases in the short
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run and remains at the new low level between the short run and the long run. Investment (I) increases in
the short run and increases further in the long run. Real money increases (Why? M is fixed and P falls).
Nominal wages (W) fall between short run and long run as the self-correcting mechanism kicks in. There
is no change in consumption (C).Why? PVLR did not change!
That is how the economy responds to a fall in government spending.
What happens when G decreases and T is fixed?
Deficits fall
r falls
I increases
No effect on labor market
This is exactly what we have in the long run above!
Example 2:
I will not draw the IS-LM curve now, but you should! I just want to highlight a few facts.
Note: when you draw the IS-LM analysis remember that if prices change - real money changes and the LM
curve will shift. I am only going to focus on the AS-AD graphically. We will do everything else in words.
Basically, let’s see how the government could get us out of a recession using fiscal policy. Fiscal policy is
the use of government spending and taxes to influence Y and P.
Suppose Consumer Confidence falls (we observe a decrease in C).
assumptions:



Let’s make some simplifying
Nominal wages are fixed in the short run. We know this is true by definition.
Households are only skittish about consumption today. No fundamentals have changed in the
economy – A and At+1 are both assumed to be fixed by firms, no effect on investment demand or
labor demand).
Household labor supply does not change in response to the fall in consumer confidence.
Note: We could relax any of these assumptions if we so desired, but it would make the analysis more
complex.
The above situation is not too far from what we observed in 1990. Consumer confidence fell (as measured
by official government statistics).
Why did consumer confidence fall in 1990?
There are a few reasons. The first is that consumers did not believe that the expansion in the 1980s could
go on forever. They were just coming out of the 70s, when economic conditions were really bad. Between
1982 and 1990, the economy did not experience a recession. Additionally, there were signs that oil prices
were on the rise. Getting involved in the Gulf War caused many Americans to fear the worst economically.
Most of these same Americans realized that it was oil prices that were to blame for the 1970s (partially true
– more on this soon). Fearing that oil prices would shoot up again (and the 70s would be revisited)
consumer confidence fell. Households stopped spending so C fell.
Another explanation of the Gulf War recession is that the banking system experienced a ‘credit crunch’.
You should all be familiar with the concept of a credit crunch from the recent financial crisis, but just in
case-- a credit crunch is a period when banks stop lending. Property markets fell in the Northeast and the
Mid Atlantic region during the late 1980s and early 1990s. Additionally, the savings and loan (S&L) crisis
made some banks more cautious. Although not technically true, we can think of this credit crunch in terms
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of our model as causing banks to hold higher excess reserves. Bank lending fell (and hence the money
supply). As a result, Investment slowed.
Regardless of the explanation (consumer confidence and a fall in C or a credit crunch and a fall in I), the
AD curve shifted in. Graphically, we represent this below:
SRAS0
(a)
P0
P1
(b)
AD1
Y1
AD0
Y*0
As C and/or I fell, AD shifted in and the equilibrium in the economy fell from (a) to (b). Y fell below Y*
(a recession) and prices fell as well. In the data for 1990, we actually see I and C falling, inflation falling
slightly and output falling. If Y < Y*, N < N* and unemployment is higher (cyclical unemployment is
positive). Some people want to work at the given market wages and cannot find a job. In the money
market, the IS curve would have shifted in (r would have fallen). There may have been an effect on LM
(bank loans dried up and M fell – not from Fed action, but from bank optimizing behavior – we now have
an example where M can fall without the Fed taking action – this is a newer literature in macro – Professor
Kayshap is on the forefront of this topic. In addition, the fall in prices would have increased M/P. The net
effect on the LM curve would have been ambiguous if M fell and P fell.)
This analysis looks very similar to that where G fell (see above).
I am working through the example for two reasons:
1. to describe the 1990s recession
2. to illustrate the potential benefits of fiscal policy
As noted above, the self-correcting mechanism could take a long time to move the economy back to Y*
when we are in a recession. We need firms to cut nominal wages and they are reluctant to do so. Because
delay is costly, in this case, there may be a role for the government to come in and speed the process along.
What could Congress and the President do to speed the process along?
Suppose that when in a recession, Congress and the President increase G. We know Y = C + I + G + NX.
If C and I fell, the President could increase G so as to offset the decline in C and I. For example, the
government could increase expenditures on highways (more construction workers) or increase the amount
of defense contracts they offer or increase spending on education (fund more teachers). All of those types
of spending will increase demand in the economy!
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Let us look at this graphically:
SRAS0
(a)=(c)
P0
P1
(b)
AD1
Y1
AD0 = AD2
Y*0 = Y2
As G increases, the AD curve will shift out from AD1 to AD2. If they get the right amount of spending,
they can move the AD curve back to its pre-recession level. But, if the government is skilled (or lucky)
enough, AD2 (aggregate demand after the government spending increases) will equal AD0 (the original
aggregate demand). Eventually, the government could spend our way out of the recession. This is exactly
what happened to get out us of the Great Depression. Y was far below Y*.
The self-correcting
mechanism was taking WAY too long to get us back to Y*. Via New Deal programs and WWII (in
particular), we were able to spend our way back to Y*.
Let’s look at the time path of key variables. I will also assume that lower consumer confidence and/or the
credit crunch remained in effect even in the long run. This is NOT likely the case. Why? Eventually,
consumer confidence will be restored and the credit crunch was likely temporary. I am just making these
assumptions because it makes the exposition easier. You should think for yourself about what happens
when C and I restore to their original level (HINT: The answer would be that G would have to decrease or
we would face inflation as we talked about in class last week, Y > Y* (as C and I returned to their initial
level and G increased). However, assuming C and I remain at their low level in the long run.
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Here are the time paths:
Today (time 0)
Short Run
Long Run
Y
P
C
G
I
W
W/P
Why does investment (I) fall a little between the short run and the long run?
Initially, as consumer confidence fell, the IS curve shifted in and interest rates fell. This puts downward
pressure on interest rates and upward pressure on investment. As G increases, the IS curve shifts out and r
returns to its initial level between the short run and the long run. As r returns to its original level, I returns
to its initial level. You should draw the IS-LM curves to replicate these facts.
Notice, the self correcting mechanism (the labor market equilibrating) would have resulted in a fall in
nominal wages, but would have taken a long time to achieve. The government, through fiscal policy (and
the Fed through monetary policy) could return the economy to the starting point much faster. This is true
of most demand shocks. We will talk about that in class this week. It is the supply shocks that are the hard
ones to manage!
Note: When we were in the recession, the government could have also cut taxes This would have
stimulated more consumption to offset the decline in C from the fall in consumer confidence.
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TAXES
Let us move to a current policy debate. Recently, President Obama asked Congress to renew a payroll tax
cut. In this section, we will examine a tax policy case from 2000. During the 2000 campaign we heard
political volleying about the effect of the Bush Tax Cut on the economy. We are going to analyze the
Bush Tax cut from the perspective of the Fall of 2000 (when one set of debates was going on). We will
revisit the Bush Tax cut in the current economic environment this week in class (I want to do more on oil
prices first).
As of late summer, late fall 2000/early spring 2001, most economists and political pundits thought the
economy was pretty close to its potential level (no one thought that we were below Y*, some even thought
we were above Y* - we will do this in class this week as well). For now, let us assume we started at Y*. I
will only draw and discuss the AD-AS market and the labor market. You should draw the IS-LM markets
yourself to round out your knowledge.
Suppose the economy initially looks like:
SRAS0
(a)
P0
AD0
Y*0
Large tax cuts should increase Consumption (C) today (assuming Ricardian equivalence does NOT hold).
Empirically, we find that Ricardian equivalence does not hold. Tax cuts lead to an increase in consumer
spending. C will increase. I may fall as the IS shifts out because r increases which we know will cause I to
falls a little – deficits tend to crowd out private investment. This is a movement along the IS curve and
the AD curve!
An increase in C will shift out the AD curve to AD1 and the short run equilibrium will be at (b):
SRAS0
P1
P0
(a)
(b)
AD0
Y*0
AD1
Y1
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In the short run, decreasing taxes will lead to an increase in Y. Most economists agreed that this would
happen. There were a few economists (even at Booth) who believed that Y would not increase in the short
run (they believe whole heartedly in Ricardian equivalence – there is evidence that Ricardian equivalence
does not hold perfectly).
Most economists and politicians were debating over the long run effects. What would happen in the long
run?
To think about the long run effects, we need to look at the labor market. There are three potential outcomes
in the labor market – I will illustrate all three.
Cutting taxes has an income and substitution effect (see Notes 7). The substitution effect says that you will
work more (labor supply shifts out, N* increases and after tax wages increase – note difference between
before and after tax wages – we have done this all before!). The income effect says that as after tax wages
increase, PVLR will increase and I don’t need to work as much – this will shift labor supply in causing N*
to fall and after tax wages to increase further! What happens to N* depends on which effect dominates.
Illustrating the three labor market outcomes:
a) Cutting taxes could cause N* to increase if the substitution effect dominates the income effect:
Ns0
Ns1
W/P
(a)
(z1)
(b)
N*0
N*z1
N1
N
(Arrow measures distance between N1 and N*z1)
There is always both an income effect and a substitution effect on labor supply when taxes are cut.
If the substitution effect dominates, then the ‘net’ effect on labor supply will be a shift to the right. In this
picture, I am only illustrating the net effect (there usually will be two shifts – if the substitution effect
dominates, we know the net effect will be a rightward shift in labor supply). The new equilibrium labor
will be N*z1 (point (z1)). Don’t forget that after tax wages rise!
I am making a further assumption (that need not hold) that the new N*z1 would be less than N1 (the short
run amount of labor supply necessary to sustain Y1 – where Y1 is the short run level of output.). You
should think about what would happen if N*z1 > N1. We will do this scenario in detail in a later set of
notes (dealing with TFP shocks).
Summary: A tax cut will lead N* to increase in the new long equilibrium if the substitution effect
dominates the income effect (small income effect relative to the substitution effect).
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b) Or, cutting taxes could cause N* to decrease if the income effect dominates the substitution effect:
Ns0
Ns1
W/P
(z2)
(a)
(b)
N*z2
N*0
N1
N
(Arrow measures distance between N1 and N*z2)
If income effect dominates, labor supply will shift in (on net). Labor will fall and equilibrium will be at
point (z2). N* will fall and after tax real wages will rise.
Note: If we are producing at N1 in the short run, we are really far from our equilibrium labor (N*z2) if the
income effect dominates.
Summary: A tax cut will lead N* to fall in the new long equilibrium if the income effect dominates the
substitution effect (large income effect relative to the substitution effect).
c) Or, cutting taxes could cause N* to remain relatively unchanged if the substitution effect and
income basically offset each other.
Ns0 = Ns1
W/P
(a) = (z3)
(b)
N*3z=N*0
N1
N
(Arrow measures distance between N1 and N*3z)
If income and substitution effect cancel out, there will be no net effect on labor supply.
Summary: A tax cut will lead N* to remain constant (not change) in the new long equilibrium if the
substitution effect exactly offsets the income effect (equal income and substitution effects).
************
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Go back and look at the three descriptions of the labor market. Notice that if the substitution effect
dominates, there will be little difference between the short run labor supply (N 1) and the new long run
equilibrium labor (Nz1). Workers are already close to working their desired amount. Sure wages will
adjust (after tax real wages rise – before tax real wages fall – in general, both firms and workers are better
off and N will not need to be adjusted). If the substitution affects dominate, workers in the short run are
already close to their long run equilibrium!
However, if the income effect dominates, workers will be far from their equilibrium labor supply (see the
above picture)! They will really need to be compensated at a much higher level (after tax wages are higher
if the income effect dominates) to maintain their short run labor supply (N1).
How will these facts translate into the AS-AD market?
Let’s think about the situation where the income and substitution effects cancel each other out (case (c)
above). In this case, N*0 = N*z3 and Y*0 = Y*z3. In the long run, we will return to their initial level of
output in the economy.
How will we get back to the equilibrium level of output given that in the short run we are at N 1 and Y1?
Because workers are working more than their equilibrium amount, nominal wages will increase and the
SRAS curve will shift in. In order to get workers to work more than their optimum, firms will need to raise
wages. The increase in wages will make production more expensive. As a result, the SRAS will shift in
(up). This is the same situation we outlined above (with the decline in G – although, the sign was
opposite).
SRAS1 (W1)
(z3)
P2
SRAS0 (W0)
P1
P0
(a)
(b)
AD0
Y*0 = Y*2
AD1
Y1
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If the tax cut has no effect on the equilibrium labor supply, then the tax cut, in the long run, will only cause
higher inflation.
You should be able to illustrate what happens when the income effect dominate on labor supply or
when the substitution effect dominates on labor supply. We did some of this in class. You will be
responsible for those situations.
What was the policy debate about?
Many economists (including Greenspan) worried that the 2001 Bush tax cut (with the economy starting at
Y*) would be inflationary. We see from our analysis that if the income effect is relatively strong (situation
z2 or z3), tax cuts would lead to higher inflation (prices would rise – we will fill in the gap between rising
prices and rising inflation this week).
Bush and his team of economic advisors argued that the
substitution effect would be large.
He said ‘My tax cut will stimulate households to take more
entrepreneurial activity’ etc. He was thinking that N would increase (for at least some households). If he is
wrong (and the income effect was large relative to the substitution effect), then his tax plan would be
inflationary!
Summary: The debate about whether his tax plan is inflationary is about the size of the income and
substitution effects with labor supply.
Which one dominates? Most economists believe that over most ranges, labor supply changes to tax rate
changes is small (we talked about this in class). In that case, I tend to believe that income and substitution
effects will, for the most part, cancel out (N will not change in the long run with tax changes). As a result,
the tax cut will tend to be inflationary in the long run (if we start at Y*).
A tax cut with no change in government spending can be inflationary (and likely will be inflationary).
Bush argued that regardless of the income and substitution effects, his plan would likely not be inflationary
because he planned to cut spending (reduce G) at the same time. In this case, taxes fall (and C increases)
and G falls. The two effects on Y (and AD) will be mostly offset! In this case, there will be no inflationary
pressures (and no short run stimulus). AD will stay relatively fixed in the short and long run. No
inflationary pressure! The key is in cutting G. Reagan made similar promises -and was not able to achieve
the cutting G part. As a result, inflation creeped up by the end of the 80s to around 4% (much higher than
the 2% per year we experienced in the late 1990s).
We will talk about the affects of a tax cut if it was implemented during a recession.
LONG RUN EFFECTS OF GOVERNMENT SPENDING
This really is quite intuitive, but I wanted you to hear me say it one time officially. In two of the three
sections, we talked about this already. Go back to the slides for Topic 4 on fiscal policy. These notes
discuss how some fiscal policy could be used to affect A (TFP) in the long run. Included in A are things
like the educated-ness of the work force, infrastructure, etc. We have talked about how when the
government runs a deficit, it diverts resources from the private sector (makes investment less). Lower I
today means lower K tomorrow. As we talked about, lower K tomorrow, means lower standing of livings
tomorrow. In this case, the government running a deficit will hurt future generations by crowding out
investment today.
This assumes that government spending (G) today has no effect on A, K or N in the future. This is not
always the case. Sometimes, especially in developing countries, increasing G today (funded by running
deficits) may actually cause Y/N to increase in the future. If the government is spending on educating its
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workers or on building roads or by fighting crime (and enforcing property rights), Y/N could actually be
higher in the future.
Let’s think about an example of crime in Russia: Suppose the Russian government decided to fight crime
today and ran a deficit to do so. In this case, I would imagine that the deficit would actually cause Y/N in
Russia to increase in the future. The government could invest in higher A in the future (enforcing property
rights, building roads, educating the work force). This is a principle of supply side economics-- using
government policies to affect the supply side of the economy. Usually, policies affect directly the demand
side of the economy (T or G). But, some policies can affect A, K or N. For example, things such as
investment tax credits - which may affect I today, could actually effect K in the future. The G.I. bill (a
transfer program which allows veterans to finance higher education or homeownership) - affects N in the
future. Funding NASA may affect A in the future.
Supply side economics is NOT trickle-down economics or Reaganomics! Those refer to giving benefits
to the rich of the economy and they will spread those benefits to their workers etc. Bush’s statement above
about using taxes to spur entrepreneurial activity (presumably for higher income households) is an example
of trickledown economics. Supply side economics is not a partisan policy. Democrats and Republicans
alike propose supply side programs - increased educational subsidies (more of a liberal position) and
investment tax credits (more of a conservative position) are both examples of supply side policies. What
we should notice is that supply side policies often take time to affect output. Most politicians are not
patient enough to follow them (their benefits occur after their term is up - which provides them with no
political gain). But, when they are implemented, they can be quite important. I believe that some of the
entrepreneurial boom we saw in the 90’s was due to the supply side policies of Reagan. A major overhaul
of the school system may provide supply side benefits in 2015 or 2020. The key is that these policies
(increasing G or cutting T) may lead to higher deficits AND better standard of livings if they are targeted
correctly.
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