the role of the government and fiscal...

TOPIC 4TOPIC 4

The Role of the Government and Fiscal Policy

The I-S Curve and Fiscal Policy

Some Equations From Lecture 1

The demand side of the economy:

Y = C + I + G + NX

Given the demand side of the economy and definitions for disposable incomeand government deficits, we have:

S(hh) + S(govt) = I + NX

S = I + NX

The fourth curve in our class is the “IS” curve. The IS curve is so namedbecause it documents the relationship between “saving” and “investment” onthe demand side of the economy (holding NX constant).

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The IS Curve

The IS curve is the representation of the demand side of the economy drawn in {Y,r} space.

Highlights the relationship between interest rates and aggregate expenditure (Y).

Interest rates affect demand through its affect on investment (I).

Key equation:

Y = C(.) + I(.) – dIr + G + NX

Remember: I = I(.) – dI r (given our linearization assumption in Topic 3) Remember: C= C(.) (given our discussion in Topic 3)

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Fourth Major Curve of the Course: IS curve

• C(.) is a function of PVLR (Y, Yf, W), tax policy, expectations (i.e., consumer confidence), liquidity constraints. (Consumption can be endogenous in model)

• I(.) is a function of A, business confidence, liquidity constraints, uncertainty, and investment tax policy. (Total investment is endogenous to our model)

• G is a function of government policy (we will discuss this shortly). (G is exogenous in our model.)

• NX will be set to zero until Topic 8.

• The IS curve relates Y to r. How do interest rates affect Y?

– As r falls, Investment increases (due to MPK and firm profit maximization behavior).

– IS curve is downward sloping in {r, Y} space.5

Demand Side Analysis (IS Curve)

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r*r*

Y* Y

r

Suppose r is set by the Fed at the level of r* (we will explore this in depth later in the course). For a given r, we can solve for the level of output desired by the demand side of the economy.

Ignore the supply side of the economy for awhile. Will return to it in Topic 6.

IS

Note: Y need not equal Y* - I drew it this way for illustrative purposes.

Some Thoughts on IS Curve

What shifts the IS curve?

Anything that causes C(.), I(.) or G to change (or NX when we model it).

What shifts IS curve to the right? (i.e., makes Y higher on the demand side of the economy)

Increase in consumer confidence (expectations of future PVLR)Permanent increase in stock market wealth.A permanent reduction in income taxes (if households are PIH or Keynesean)A temporary reduction in income taxes (if households are Keynesean or Liquidity Constrained PIH).An expected future increase in TFP (stimulates investment demand).An increase in government spending (i.e., war).

Changes in r WILL NOT cause IS curve to shift (causes movement along IS curve).7

Suppose Consumer Confidence Falls

Suppose consumer confidence falls (and no effect on Y*). IS curve will shift in.

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r*r*

Y*Y

r

ISIS1

Y1

C(.) falls

Assume that I(.), NX, and G do not change (all else is equal)

Fiscal Policy

Fiscal policy is the use of government spending (G), taxes (tn, tc) and transfers (Tr) to stabilize the economy.

Governments can have:o Output targetso Price targetso Unemployment targets

Stabilizing the economy means moving the economy towards its targets. We will ignore price targets for now (we have no prices in our model yet).

Suppose the government has an output target and suppose that target is Y* (we will also explain why Y* is a good target later in the course).

Fiscal policy then would be the manipulation of G, taxes and transfers to move the economy towards Y*. (Assumes government knows where Y* is - we will discuss other drawbacks to fiscal policy later in the course). 9

Example of Fiscal Policy: Consumer Confidence Falls

Government can undo the decline in consumer confidence by increasing G or decreasing tn - this is fiscal policy

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r*r*

Y*Y

r

IS = IS2IS1

Y1

C(.) falls

G increases

Compute Change in G: If ΔG = -ΔC(.), Y will remain unchanged (taking r as fixed)

A Look at U.S. Debt and Deficits

U.S. FEDERAL DEFICIT (RELATIVE TO GDP)

U.S. TOTAL PUBLIC DEBT (RELATIVE TO GDP)

US FEDERAL SPENDING 2016

U.S. PUBLIC INTEREST PAID (RELATIVE TO GDP)

WHO OWNS U.S. DEBT?

The Cyclicality of Government Budget Deficits

Some Additional Structure on Taxes and Transfers

Let us start with some definitions about debts and deficits.

Tax Revenues = tnY (where tn is the marginal tax rate on income)

Transfers Payments = Tr – g Y (where g proxies for how transfers go up when aggregate income falls – i.e., welfare transfers are higher in recessions)

Rationale for specifications:

1. When Y increases, tax revenues increase (more earnings in economy).

- This is built into the tax code. - You are taxed based upon what you earn.

2. When Y increases, transfers payments fall (less people on welfare)

- This is built into our social programs.- We transfer more money to people when their income is low. 19

Some Deficit Terminology

Actual Government Deficits

= Outlays (G and Tr) – Revenues (T) = G + Tr – g Y - tnY = G + Tr – (g + tn)Y

Note: For now, ignore other government revenues and expenses (like interest on government debt). See text for further discussion if interested.

Definition: Structural Budget Deficit is the deficit that would exist if the economy were at Y*:

Structural Budget Deficit = G + Tr – (tn + g)Y*

Note: Difference between structural deficits and actual deficits is only due to differences between Y and Y*.

Cyclical Budget Deficits = Actual Budget Deficits - Structural Budget Deficits.Cyclical deficits occur anytime Y does not equal Y*!

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The Nature of Deficits

• Deficits are countercyclical! (They rise when Y falls and fall when Y rises)

• Even if the government has a policy (combination of G and T) that would lead to no deficits at Y* (the target level of output for the economy), deficits could still occur.

The reason: Y does not always equal Y*.

• Why do we get countercyclical deficits?

Welfare Payments, Unemployment Insurance, and Tax System dampen the effects of consumption over the business cycle.

– T goes up when times are good (like in the late 1990s).– G/Tr goes up when times are bad (welfare payments).– We refer to such policies that dampen consumption as “automatic stabilizers”

• Given “automatic stabilizers” (and potentially proactive governmental fiscal policies), cyclical deficits seem to be an inherent part of our economy.

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Should Governments Try To Prevent Deficits?

• Examples: U.S. Balanced Budget Amendment. Maastricht criteria for entry to European Economic and Monetary Union (EMU) that deficit/GDP be 3% or less and that debt/GDP be 60% or less.

• Benefits: Limit Spending: If spend today, government must:

1) Raise Taxes Now (changing taxes frequently creates economic uncertainty)2) Raise Taxes in Future (higher taxes cause disproportionately more distortions )3) Print Money In Future (could lead to inflation)

• Is there a cost? Yes - balanced budget amendments can make economic situations worse. Refer back to the example earlier in this lecture when consumer confidence fell.

As Y fell, tax revenues fell. As tax revenues fell, deficits (cyclical) increased. If the government had to balance the budget, they would either have to cut G or increase T -both of which would cause the IS curve to shift further to the left.

• Conclusion - it may be bad to have policies requiring governments to eliminate all deficits, but there may be some benefits from eliminating structural deficits. 22

Government Spending at Y* (model preview)

Revisiting Potential Output (Y*)

Potential output is the level of output in the economy when the labor market clears

Formally: Y* = A K1-α (N*)α

Where we are heading:

o Short run: period of time when the labor market does not clearo Long run: period of time when the labor market clears (given A, K and other

inputs).

From topic 2, market clearing N* depends on:

o Labor Supply: PVLR, taxes, population, value of leisureo Labor Demand: A and K (and eventually other inputs like oil prices)

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Increase in G at Y*: Investment Adjusts

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r*

Y* Y

r1

IS = Y=C+I+G

LRAS = Y =Y*=f(A,K,N*)

Suppose we start at Y* such that Y is pinned down by the supply side (i.e., labor markets clear, all resources used efficiently)

Increase in G at Y*: Investment Adjusts

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r*

Y* Y

r1

Assumption: Assume increase in G has no effect on A (for now)

Model: Increase in G has no effect on N* (no effect on labor supply or labor demand (holding A fixed)). So, no effect on Y*.

IS = Y=C+I+G

LRAS = Y =Y*=f(A,K,N*)

IS1 = C+I1 +G1G

I

What is the Effect of Running a Deficit at Y*?

Situation 1: Crowding Out of Investment:

Equation 1: Y = C + I + G Equation 2: SHH + Sgvt = I (if NX = 0)

If Y is pinned down by supply side of economy (such that ΔY = 0 if G increases), then either C or I must fall to offset increase in G (i.e., ΔG = - ΔI).

Why would I fall? Increase in interest rates (we will prove once we build a model of money market).

What is the effect of falling I (due to increased G) on future generations? Lower I today, means lower K tomorrow. Lower K tomorrow means lower Y* tomorrow (lower economic growth).

If at Y*, increase in deficit will hurt future generations unless the deficit has a non-trivial effect on A (given Cobb Douglas Production: If %ΔA > 0.3 * %Δ K, then deficit could help future generations.)

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What is the Effect of Running a Deficit at Y*?

Situation 2: Ricardian Equivalence:

Adjustment occurs on C as opposed to I (to keep Y at Y*)

Definition: Ricardian Equivalence: Theory that states that consumers’ behavior is equivalent regardless of whether the government finances G (govt. expenditures) through increased taxes or through increased debt

Key: If the government floats debt to finance the spending today, consumers realize that the government, at some time in the future, will have to raise taxes to pay back the debt.

Summary: A reduction in taxes today (or an increase in G today) will be seen as being accompanied by higher taxes in the future. Households will save today to fund the future tax increases (they expect disposable income in the future to fall). National Saving would remain unchanged.

In terms of equations: Y is fixed, C falls and Shh goes up (prevents crowding out of investment ; I can stay fixed) 28

Does Ricardian Equivalence Hold?

For the most part, there is little evidence to support the existence of Ricardian Equivalence.

Why? MyopiaLiquidity ConstraintsHigh Levels of ImpatienceDo not care about bequests/future generationsTiming of Taxes is Important (taxes are not lump sum)Even if taxes go up in the future, only adjust savings by small amounts each period.

For the rest of the course, we will assume consumers are “non Ricardian” unless told otherwise. This means that consumers will not adjust their consumption downward today in expectation of an increase in taxes tomorrow.

Ricardian consumers, however, would adjust their consumption downward today in expectation of increases in taxes tomorrow (because PVLR falls) in response to a permanent increase in G.

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Summary: Effects of Deficit Financed Government Spending at Y*

Benefits:

o Can potentially increase future growth if it increases future TFP (think infrastructure spending).

Costs:

o Crowds out private investment (which hurts future generations)o Have to pay distortionary future taxes (which hurts future generations)o Government spending is often inefficient (which wastes resources)

Caveats:

o There is another margin of adjustment in an open economy: borrow from the world. Hurts future generations because some future income will flow out of the country to repay the debt.

o Equity issues within current generation may be important – but those are separate from deficit issues. Deficits focus on equity across generations. 30

Government Spending During Recessions

Summary: Effects of Deficit Financed Government Spending During Recessions

Benefits:

o Can potentially increase future growth if it increases future TFP (think infrastructure spending).

o Can utilize slack resources in the economy – If economy is belowpotential, government spending can generate more output.

Costs:

o Crowds out private investment (which hurts future generations)o Have to pay distortionary future taxes (which hurts future generations)o Government spending is often inefficient (which wastes resources)

Note:

o Other costs and benefits are the same as increasing G at Y* 32

Government Spending Multiplier

Tries to measure the net change in GDP today from a given change in government spending today.

Measured by ∂Y/ ∂G

By construction, only includes current GDP

o Mobilizing slack resourceso Crowding out of investment

Ignores potential future costs

o Does not include potential effects on future productivityo Does not include effect of potential distortionary tax increase in future

Ignores that slack resources also have value

o Slack workers value leisure and slack machines forgo depreciation. 33

How Big Can the Multiplier Be?

In the long run (when Y = Y*), the multiplier is zero

o Interest rates adjust and crowds out investmento Output is pinned down by the supply side of the economy

When economy is below Y* (recession), the multiplier can be significant

o Slack resources are mobilizedo Interest rate effect is smaller such that investment is not perfectly crowded

out.o Output determined – in part – by demand side of the economy.

This simple model underlies the old “Keynesian” intuition often seen in the popular press advocating increased government spending during recessions.

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A Simple Model of a Government Spending Multiplier

Focus on demand side only (no link to supply side)

Assume interest rates do not adjust to change in government spending

o A crazy assumption (we will model interest rates next week).

o Not so crazy when interest rates are “stuck” at zero (what economists call the Zero Lower Bound).

o Ignoring interest rate changes assumes away the crowding out of investment.

Assume consumers do not adjust spending to changes in government spending.

o Implies consumers are not Ricardian.

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Why is There a Potential “multiplier” When Y < Y*?

Suppose we have the following model:

C = a + b(Y – T) << assume some fraction of consumers are liquidity constrained so they act Keynesian>>

I = I0 – I1 r <<Investment is negatively related to interest rates>>

T = tn Y <<Marginal tax rate on labor income>>

Other assumptions:

Transfers = 0 ; G = G0 ; Y << Y* ; closed economy (NX = 0 always)

What is the equilibrium level of Y?

Y = C + I + G = a + b(Y – tnY) + I0 – I1 r + G0

Solve for Y (Use algebra – one equation, one unknown)

Y = [a + I0 – I1 r + G0] / [1-b(1-tn)] 36

What is the private sector multiplier in the Simple Model?

Given the Simple Economy on Previous Page:

Y = [a + I0 – I1 r + G0] / [1-b(1-tn)]

What is the multiplier of a change in government spending (G) on Y?

dY/dG = 1/[1-b(1-tn)]

What is b? Some estimates range from 0.3-0.4 in recession.Where are the estimates from? -- Micro data analyzing tax rebates (a change in taxes not a change in government spending).

What is t? Marginal tax rate – roughly 0.25-0.35

What is the government spending multiplier in this simple model?

dY/dG is approximately 1.3 (if b = 0.35, t=0.3) 37

The Simple Keynesian Multiplier

Upper bound on the true (or net) government spending effect on output.

o Ignores the crowding out of investment by holding interest rates fixed.

o Ignores consumer responses by imposing Ricardian equivalence.

o Ignores any supply side effects (prices may adjust – more on that when we build a model of prices).

Government spending multipliers will be higher in recessions

o More slack resources can be mobilized without “crowding out” investment.

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Estimated Government Policy Multipliers in the Data

Typically estimated by looking at correlation between G and Y in time series data.

o Difficult because government mainly tries to stimulate economy in recessions (build in negative correlation)

o However, need to focus on government spending in recessions because multipliers are different when Y=Y* and Y < Y*.

o Hard to do proper counterfactuals

Two famous papers using “wars” as instrument:

o Christy Romer: 1.6; Robert Barro: 0.6.

Some recent studies look at state-level spendingo Large multipliers; 1.5 - 2.0o But, by construction, no interest rate response (no crowding out) 39

My Thoughts

1. In the long run, multiplier close to zero

o Output determined by supply side of the economyo Most government spending does not increase TFP

2. In recessions, multiplier positive but likely small

o Output determined by demand side of economy (utilizes idle resources)o But typically interest rates adjust, so investment partially crowded out.o Also, inefficiencies likely to be huge – how do you spend $800 billion

quickly and efficiently.

3. Often a mismatch between “slack resource effect” and “increasing TFP effect”

o Lots of slack resources in Detroit. Do we need more roads in Detroit?

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Tax Cuts During Recessions

Another way to stimulate the economy during recession is cut taxes

o Consumption: labor income taxes, consumption taxeso Investment: corporate income taxes, investment tax credits

Common view is that tax cuts are less effective at stimulating GDP (for a given $1 increase in deficit)

o Lower bang for bucko Do not get direct effect of government spending

Recent research says they can be effective:

o Tax rebates to households (C)o Firms are very responsive to bonus depreciation allowance (I)

Different efficiency trade-offs (less wasteful, no direct effect on TFP)41

Definition: Supply Side Economics

Supply Side Economics

Any fiscal policy designed to stimulate the supply side of the economy (A, K and N)

Examples:

1) Changing marginal tax rates (stimulate N)

As discussed before , these policies may not have big effects (off setting income effects and substitutions effects ; empirically small estimates of labor supply response).

2) Subsidizing A and K (investment tax credits, research and development subsidies, subsidizing education, etc.)

These programs have been shown as being effective ways to promote economic growth within an economy.

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A Discussion of Inequality

Inequality Mania

Recent empirical work showing inequality is increasing:

o Income inequality (Kevin Murphy, Larry Katz, Emmanuel Saez, Thomas Piketty, Ed Glaeser).

o Consumption Inequality (Steve Davis , Me)

o Employment Inequality (Kevin Murphy, Bob Topel, Me)

o Wealth Inequality (Thomas Piketty, Emmanuel Saez)

What are the causes of increased inequality?

Is increased inequality detrimental to a society?

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Thomas Piketty Capital in the Twenty First Century

Book: “Capital in the Twenty First Century” - Worldwide best seller.

Documents wealth inequality increases around the developed world.

Claim: economic conditions are such that eventually most wealth will be concentrated in the hands of the rich.

o Forces will continue to make inequality grow.o Reason: rate of return on capital > income growth (i.e., r > g)

Policy prescription: Tax wealth

What we will do: Walk through the Piketty argument and discuss necessary assumptions (and plausibility of assumptions). Draw on discussion by Justin Wolfers (http://users.nber.org/~jwolfers/papers/Comments/Piketty.pdf)

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U.S. Income Inequality: Top 10% “Kuznet’s Curve”

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Cross-Country Income Inequality: Top 1%

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OECD Cross-Country Income Inequality: 90-10 Ratio

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U.S. Wealth Inequality

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Some Key Ingredients for the Piketty Story to hold

An identity: Define ωt as the capital share of total income in year t. By definition, that is:

This is not controversial. By definition:

Note: Under a Cobb-Douglas production function, ωt =1-α and is fixed over time (at some number like 0.3).

Note: rt is an average return across different types of capital.51

*t tt

t

r KY

( / )t t t t t tY w p N r K

Some Key Ingredients (in bold) for the Piketty Story to hold

Start with our identity and assume interest rates are constant over time:

Assume there is no depreciation of the capital stock such that ΔKt = It:

• Assume saving is a constant fraction of income (remember S = I):

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tt

t

KrY

1t tt

t

K IrY

1t tt

t

K s YrY

Some Algebra….(and one more assumption)

Assume Y grows at a constant rate “g”

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1t tt

t

K sYrY

2 1( ) tt

t

t t s YK s YrY

2 (1 )t tt

t

ts g YK s YrY

32 (( 1 )1 ) tt t

tt

s g YK s g Y s YrY

0(1 )t

t tt

t

s Y gr

Y

Piketty’s Argument

Piketty argues that g will fall going forward due to technological progress slowing down or aging of population.

Since r and s are assumed fixed, this will increase the capital share going forward

Since rich own capital, this will increase share of total income accruing to the rich

o Concludes increasing inequality as a “fundamental law of capitalism”

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tsrg

Three Key Ingredients of Piketty’s Argument

Interest rates are constant over time

o In our model, interest rates equal MPK

o As capital increases, MPK falls, so interest rates fall (lower capital share)

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tsrg


No depreciation of capital stock

o Capital stock depreciates over time

o Correct formula with depreciation:

o Implies capital share rises more slowly as g decreases (more capital investment is needed to replace depreciated capital)

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tsrg

tsr

g


National saving is a constant fraction of income

o Savings not constant

o According to PIH, as PLVR of rich increases going forward, savings rate will decrease (consume more today).

o Rich will eat some of their extra anticipated future income.

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tsrg

Some Other Issues

Most of the increased inequality within the U.S. NOT due to changes in capitalincome. The rich are getting richer because of labor income.

How do we think about labor income vs. capital income for the really rich?

High salary growth in finance, skilled professionals, CEOs, etc. Has nothing to do with the increase in capital income.

Do we only care about the top 1% (or 10%) relative to the median? What about the gap between the 75th percentile and the 25th percentile? That has grown dramatically as well (college vs. non-college premium).

What is the optimal policy response if we care about inequality? Taxing the rich? Helping to educate the poor? Allowing high skilled immigration?

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Are there benefits to income inequality?

– In human capital models, unequal returns to skill are necessary to induce people to invest in human capital.

– “The widening inequality in earnings and the buoyant demand for skilled workers also indirectly encourages greater growth in the economy by increasing the incentives for young people to invest in themselves.” Gary Becker, The Economics of Life

Outside Piketty: Some Final Thoughts

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Is income inequality detrimental to society?

– The economic literature has focused on documenting trends in inequality and modeling the determinants of income inequality.

– However, the consequences of inequality are relatively understudied due to some challenges in research design.

– How do we think about:

o The health of societies that are unequal? o Intergenerational mobility? o Income segregation (do poor and rich people choose to live next to each

other)? o Political participation (who votes? who gives money to candidates?)

Outside Piketty: Some Final Thoughts

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