Ch. 12: Fiscal Policy Pt. II
Actual vs. Full Employment Budget
Full Employment Budget: because of automatic stabilizers, the actual budget deficit or surplus will
vary with the size of GDP. (examples of Automatic Stabilizers: unemployment compensation,
corporate profit tax, progressive income tax)
Actual budget deficit or surplus… may differ greatly from full employment budget deficit or surplus
estimates. Actual budget consists of structural deficit (or full employment) and the cyclical deficit.
Structural deficits… occur when there is a deficit in the full-employment budget as well as the actual
budget. Discretionary fiscal policy is reflected in deliberate changes in this structural deficit.
Fiscal Policy and the Crowding-out Effect

The Crowding-out Effect:
-- indicates that the increased borrowing to finance
a budget deficit will push real interest rates up
and thereby retard private spending, reducing the
stimulus effect of expansionary fiscal policy.

Likewise, a restrictive fiscal policy will reduce real
interest rates and "crowd in" private spending
Crowding-out Private Spending in the
Loanable Funds Market
Price
level
S1
r1
e1
Under this model, fiscal
policy exerts a decrease on
real GDP.
e2
D2
D1
Q1 Q2


Loanable
Funds
In order to finance the budget deficit, the govt borrows from the
loanable funds market, increasing aggregate demand (from D1 to D2).
The supply of loanable funds decreases “crowding out” private
investment.
A Visual Presentation of the Crowding-Out
Effect in an Open Economy
Decline in
Private
Investment
Increase
In Budget
Deficit






Higher Real
Interest Rates
Inflow of
An increase in govt.
Financial
borrowing to finance
Capital
an enlarged budget
from Abroad
Appreciation
deficit places upward
of the Dollar
pressure on real interest rates.
Decline in
Net Exports
This retards private investment
and thereby Aggregate Demand.
In an open economy, higher interest rates attract capital from abroad.
As foreigners buy more dollars to buy U.S. bonds and other financial
assets, the dollar appreciates.
In turn, the appreciation of the dollar causes net exports to fall.
Thus, as a result of increased budget deficits, higher interest rates
trigger reductions in both private investment and net exports, which
has the opposite effect of the expansionary impact of a budget deficit.
“New Classical” View of Fiscal Policy

The New classical view stresses that:


debt financing merely substitutes higher future
taxes for lower current taxes
When debt is substituted for taxes:

people will save the increased income so they will be
able to pay the higher future taxes

Therefore, the budget deficit does not stimulate
aggregate demand (which is what it is supposed to do).

According to the new classical view, fiscal policy is
completely impotent. It does not effect output, employment,
or real interest rates.
Tax Rates
High marginal tax rates will supposedly tend
to retard total output because they will:
1. Discourage work effort and reduce the productive
efficiency of labor.
2. Adversely affect the rate of capital formation.
Fiscal Policy:
-- Problems with Proper Timing

Various time lags make proper timing of changes in discretionary
fiscal policy difficult.

Discretionary fiscal policy is like a two-edged sword; it can
both harm and help.



Recognition Lag — leading indicators may not be up-to-date;
recessions often are not recognized for 6 months
Administrative Lag — wheels of government turn slowly
Operational Lag — time for spending to take effect may be slower
than tax changes
Why Proper Timing of
Fiscal Policy is Difficult
Price
level
LRAS
SRAS
Shifts in AD are difficult to forecast!
P0
P1
E0
e1
AD1 AD0
Y1 YF



Goods & Services
(real GDP)
We begin long-run equilibrium (E0) at the price level P0 and output YF.
At this output, only the natural rate of unemployment is present.
An investment slump and business pessimism result in an unanticipated
decline in AD (to AD1). Output falls and unemployment increases.
After a time, policymakers institute expansionary fiscal policy seeking
to shift AD back to AD0, but by the time fiscal policy begins to exert its
primary effect, private investment has recovered and decision makers
have become increasingly optimistic about the future.
Why Proper Timing of
Fiscal Policy is Difficult
Price
level
LRAS
P3
e4
P2
P0
P1
SRAS2
SRAS
e2
E0
e1
AD2
AD
0
AD1
Goods & Services
(real GDP)
Y1 YF Y2



Thus, just as AD begins shifting back to AD0 by its own means,
the effects of fiscal policy over-shift AD to AD2.
The price level in the economy rises as the economy is now
“overheated”.
Unless the expansionary fiscal policy is reversed, wages and
other resource prices will eventually increase, shifting SRAS
back to SRAS2 (driving the price level up to P3).
Why Proper Timing of
Fiscal Policy is Difficult
Price
level
LRAS
P2
P0
SRAS
e2
E0
AD0
YF Y2


AD2
Goods & Services
(real GDP)
Alternatively, suppose an investment boom disrupts the initial
equilibrium shifting aggregate demand out to AD2, placing upward
pressure on prices.
Policymakers respond by increasing taxes and cutting government
expenditures, but by the time that the restrictive fiscal policy has
had an opportunity to take effect, investment returns to its normal
rate (shifting AD2 back to AD0).
Why Proper Timing of
Fiscal Policy is Difficult
Price
level
LRAS
P2
P0
P1
SRAS
e2
E0
e1
AD2
AD
0
AD1
Goods & Services
(real GDP)
Y1 YF Y2



Thus, just as AD begins shifting back to AD0 by its own means,
the effects of fiscal policy over-shift AD to AD1.
The price level in the economy falls as the economy is now
thrown into recession.
Because fiscal policy does not work instantaneously, and since
dynamic factors are constantly influencing private demand,
proper timing of fiscal policy is not an easy task.
Empirical Evidence on
the Impact of Fiscal Policy
Percent
of Real GDP
26
Expenditures
24
22
Deficits
20
Revenues
18
<
1960
1965
1970
1975
1980
1985
1990
1995
2000
Year

Fiscal policy during the past 4 decades:

Since 1960 the federal budget as a % of GDP has
generally increased during recessions and declined
during periods of economic expansion.
Empirical Evidence on
the Impact of Fiscal Policy
Component as a % of GDP
Time
Period
Real
Federal
I
nterest
Deficit
Rate A
% Of GDP
Gross
Net
Personal
Private
Foreign
Consumption Investment Investment
Gross
Investment
Less Net
Net
Foreign
Investment Exports
1976–1980
1983–1987
Differential B
2.9
5.1
+2.2
1.9
7.5
+5.6
62.3
65.0
+2.2
17.5
16.7
-0.8
0.0
2.6
+2.6
17.5
14.1
-3.4
- 0.8
- 2.6
-1.8
1960–1974
1981–1994
Differential B
0.9
4.0
+3.1
2.4
6.1
+3.7
62.0
65.8
+3.8
15.7
15.3
-0.4
- 0.5
1.6
+2.1
16.2
13.7
+2.5
0.2
- 1.6
-1.8
A
B Later
period minus earlier period. As the data of the
first column indicate, the federal deficits were larger
during the later period.
Source: Derived from the Economic Report of the President

The real interest rate was derived by subtracting
the annual inflation rate as measured by the
GDP deflator from the AAA corporate bond rate.
Consumption and Investment:


As deficits rose from ‘83 to ‘87, consumption rose (from 62.2%
to 65%), consequently savings fell (also in ‘81-‘84 period).
Appreciation of the dollar, capital inflow and net exports:


As deficits rose from ‘83 to ‘87, net foreign investment rose
(from 0% to 2.6%), while net exports fell. (also in ‘81-‘84 period).
This is consistent with the crowding-out model.