Demand Management Policy: The Fiscal Approach

1. Demand Management Policy: The Fiscal Approach Chapter 11

2. Introduction • The multiplier model highlights the role of aggregate demand management policies. • These include monetary policy and fiscal policy.

3. Introduction • Fiscal policy – the deliberate change in either government spending or taxes to stimulate or slow down the economy.

4. Introduction • Expansionary fiscal policy involves decreasing taxes or increasing government spending. • Contractionary fiscal policy involves increasing taxes or decreasing government spending.

5. The Story of Fiscal Policy • An economy needs a countershock to get out of a deep recession. • Countershock – a jolt in the opposite direction of the shift in aggregate demand to get the multiplier working in reverse.

6. The Story of Fiscal Policy • Individuals, as individuals, are often not prepared to increase their spending during a recession. • Collective action may be needed.

7. The Story of Fiscal Policy • With fiscal policy, government could provide the needed increased spending by decreasing taxes, increasing government spending, or both. • The multiplier would then take over and expand the effect of the initial spending.

8. Aggregate Demand Management • Aggregate demand management is government's attempt to control the aggregate level of spending in the economy.

9. Aggregate Demand Management • Demand management is necessary because the effects are significantly different when one person does something rather than everyone doing the same thing.

10. Aggregate Demand Management • Keynesians argued that, in times of recession, spending is a public good that benefits everyone.

11. Fighting Recession: Expansionary Fiscal Policy • The economy is below potential income during a recession. • There is a recessionary gap. • Recessionary gap – the difference between equilibrium income and potential income when potential income exceeds equilibrium income.

12. Fighting Recession: Expansionary Fiscal Policy • Fighting recession requires expansionary fiscal policy. • Assuming that government knows the value of the multiplier, the right amount of money could be injected into the economy.

13. Fighting Recession : Expansionary Fiscal Policy • When multiplied, the increase in aggregate demand closes the recessionary gap.

14. LRAS LRAS AE1 AE0 Initial AE increase G = $60 Multiplier effect $60 $120 SAS E1 AD’1 AD0 AD1 Recessionary gap = $180 $180 $1,000 $1,180 $1,000 $1,180 Fighting a Recession, Fig. 11-1, p 263 E2 Real aggregate expenditures Price Level AE = 333 + 0.67Y mpc = 0.67 0 0 Real income Real income

15. Fighting Inflation: Contractionary Fiscal Policy • When inflation begins to accelerate beyond potential output, fiscal policy works in reverse by decreasing expenditures that are too high. • Fighting inflation requires contractionary fiscal policy.

16. Fighting Inflation: Contractionary Fiscal Policy • If the quantity of aggregate demand exceeds potential income at that price level, there will be excess demand and pressures for inflation.

17. Fighting Inflation: Contractionary Fiscal Policy • Output may temporarily exceed potential output because firms and workers may be slow to raise prices and wages. • Soon shortages and accelerating inflation will drive the economy back to its potential income.

18. Fighting Inflation: Contractionary Fiscal Policy • Government should decrease its expenditures by an amount that reflects the magnitude of the multiplier.

19. Fighting Inflation: Contractionary Fiscal Policy • This expenditure reduction would remove the inflationary gap. • Inflationary gap – the difference between equilibrium income and potential income when equilibrium income exceeds potential income.

20. LRAS LRAS AE0 AE1 B P2 G = $200 SAS1 P1 A P0 SAS0 Inflationary gap = $1,000 AD0 AD1 $4,700 $5,000 $ 5,000 Fighting Inflation, Fig. 11-2, p 264 E1 Real aggregate expenditures Price Level AE = 800 + 0.8Y E2 mpc = 0.8 $4,000 Real income $ 4,000 Real income

21. The Questionable Effectiveness of Fiscal Policy • There are two ways to think about the effectiveness of fiscal policy – in the model and in reality.

22. The Questionable Effectiveness of Fiscal Policy • The effectiveness of fiscal policy in reality depends on the government's ability to perceive a problem, and react appropriately to it.

23. The Questionable Effectiveness of Fiscal Policy • If the model is correct in describing the economy, and if government acts quickly enough in a countercyclical way, depressions can be avoided.

24. The Questionable Effectiveness of Fiscal Policy • A countercyclical fiscal policy is one in which the government offsets any shock that would create a business cycle.

25. The Questionable Effectiveness of Fiscal Policy • Fine tuning is the term used to describe a fiscal policy designed to keep the economy always at its target or potential level of income.

26. The Questionable Effectiveness of Fiscal Policy • All economists now recognize that the dynamic adjustment in the economy is extraordinarily complicated, especially when taking into account reasonable expectations of future policy.

27. Alternatives to Fiscal Policy • Changes in autonomous C, I, G, X, or IM can achieve the same results as fiscal policy. • Changes in any of the five can achieve the same results as fiscal policy.

28. Alternatives to Fiscal Policy • Any policy that can change autonomous expenditures without having offsetting effects on other expenditures can be used to influence the direction and movement of aggregate income.

29. Alternatives to Fiscal Policy • There are three alternatives to fiscal policy: • Directed investment policies. • Trade policies. • Autonomous consumption policies.

30. Directed Investment Policies: Policy Affecting Expectations • Directed investment policies are those affecting expectations to increase investment.

31. Directed Investment Policies: Policy Affecting Expectations • A numerical example: • By how much must autonomous investment increase, if income is $400 less than desired and the mpc is 0.5? • Working backward, the multiplier is 2, so autonomous investment must increase by $200.

32. Directed Investment Policies: Policy Affecting Expectations • Directed investment policies include rosy scenario policies and financial guarantees.

33. Rosy Scenario • Rosy scenario policies involve talking the economy well. • Almost invariably, government officials paint optimistic pictures as to where the economy is headed.

34. Rosy Scenario • These have been called rosy scenario policies—government policies of making optimistic predictions and never making gloomy predictions. • Upbeat predications must be credible for rosy scenario policies to work.

35. Financial Guarantees • Another way to influence investment is to protect the financial system by government guarantees or promises of guarantees. • An example would be a government policy preventing bank failures.

36. Financial Guarantees • Still another way in which government can influence investment is through influencing the interest rate.

37. Trade Policy and Export-Led Growth • Any governmental policy that increases autonomous exports and decreases autonomous imports will also have multiplied effects on income. • These policies are called export-led growth policies.

38. Trade Policy and Export-Led Growth • Export-led growth policies– designed to stimulate exports and increase aggregate expenditures on Canadian produced goods.

39. Trade Policy and Export-Led Growth • Alternatively, any policy that will lower imports, such as increasing tariffs, will have the same expansionary effect on income.

40. Trade Policy and Export-Led Growth • A numerical example: • By how much must net exports increase, if income is $300 less than desired and the mpc is 0.33? • Working backward, the multiplier is 1.5, so net exports must increase by $200.

41. The Global Economy Is Interdependent • If one nation follows an export-led growth policy, it forces other nations into an import-led decline for its economy. • It can reasonably be expected that other nations will retaliate against an export-led growth policy.

42. The Global Economy Is Interdependent • As a consequence, many economists support free trade agreements such as NAFTA (North American Free Trade Agreement).

43. Exchange Rate Policies • The trade balance can also be affected through exchange rate policy. • An exchange rate policy deliberately affects a nation’s exchange rate in order to affect its trade balance.

44. Exchange Rate Policies • A low value of a country's currency relative to currencies of other countries encourages exports and discourages imports. • A high value of a country's currency relative to currencies of other countries discourages exports and encourages imports.

45. Autonomous Consumption Policy • Autonomous consumption policy is a third alternative. • Increasing the availability of consumer credit to individuals increases consumption.

46. Real World Examples • The effect of wartime spending in the 1930s and 1940s and the prolonged expansion of the mid-1990s to early 2000s illustrate how fiscal and other expenditure policies work.

47. Fiscal Policy in World War II • Taxes rose during World War II, but government expenditures rose much more. • The deficit shot up and real income rose by more than the increase in the deficit.

48. Fiscal Policy in World War II • But where is the price-level increase one would expect? • One would normally expect a huge inflation.

49. Fiscal Policy in World War II • The wartime expansion was accompanied by wage and price controls and rationing.

50. Fiscal Policy in World War II • Owing to the death of soldiers and sailors, unemployment was unintentionally reduced.