fiscal

stimulqte business investment, consumption, and employ- ment, was perhaps the shining example of fiscal policy dur- ing the r96os. The tax cut seemed to work wonders, increasing disposable income and consumption. The unemployment rate dropped under 5 percent for the first time in seven years, the inflation rate dipped under 2 percent, and the federal budget deficit in r964 equaled only o.9 percent of GDp (compared with an average of 2.6 percent since i98o).

Discretionary fscal poliry is a demand-manq.gement policy; the objective is to increase or decrease aggregate demand to smooth economic fluctuations. Demand- management policies were applied during much of the r96os. But the r97os brought a different probiem-stagflation, the doubie troubie of higher inflation and higher unemployment resulting from a decrease in aggregate supply. The aggregate sup- p1y curve shifted left because of crop failures around the world, sharply higher OpEC-driven oil prices, and other adverse supply shocks. Demand-management policies are ill suited to cure stagflation because an increase of aggregate demand would increase infla- tion, whereas a decrease of aggregate demand would increase unemployment.

Other concerns also caused poliry makers and economists to question the effectiveness of discretionarv / I fiscai poiiry, These concern's

*€ included the difficulty of esti- mating the natural rate of unempioyment, the time lags involved in implementing fiscal poliry, the distinction between current income and permanent income, and the possible feedback effects of fiscal policy on aggregate sup- ply. We consider each in turn.

lixhibit 5 When Discretionary Fiscal Policy 0vershoots Potential 0utput

14.O 14.2 Real GDP (trillions of dollars)

to AD'. In the short run, this stimulation of aggregate demand expands output to $r4.2 trillion and reduces unemployment to 4.o percent, so the poiiry appears successful. But stimulating aggregate demand opens up an expansionary gap, which in the long run results in a leftward shift of the short-run aggregate supply curve. This reduction in aggregate supply pushes up

140

o o o '3 130

Discretionary fi scal policy is a demand-management

policy; the objective is to increase or decrease

aggregate demand to smooth economic

fluctuations.

prices and reduces real GDP to $r+.o trillion, the economy's potential. Thus, poliry mak- ers initially believe their plan worked, but pushing produc- tion beyond the economy's potential leads only to infla- tion in the long run.

Fiscal Policy

.qL9..ig.tilis.q. ". " ".. gg Given the effects of fiscal poi-

iry, particularly in the short run, we should not be sur-

FHssafi F*63ep amc* €hs ffi mtucwm $ ffimte #S q$*,n#mpFcxynerecru€

As we have seen, the unemployment that occurs when the economy is producing its potential GDp is called the naturs.l rate of unemployment. Before adopting discre_ tionary poiicies, public officials must coffectly estimate this naturai rate. Suppose the economy is producing its potential output of $r4.o triltion, as in Exhibit 5, where the natural rate of unemployment is 5.o percent. Aiso suppose that public officials mistakenly believe the naturai rate to be 4.o percent, and they attempt to reduce unemployment and increase real GDp through discretionary fiscal poliry. As a result of their poliry, the aggegate demand curve shifts to the right, from AD

prised that elected officials might try to use it to get reelected. The link between economic performance and reelection success has a long history. Ray Fair of Yale University examined presidential elections dating back to r9r6 and found, not surprisingly that the state of the economy during the election year affected the outcome. r Specifically, Fair found that a declining unemployment rate and strong growth rate in GDP per capita increased election prospects for the incumbent party. Clearly, a weak economy in zoo8 helped Barack Obama defeat the incumbent party candidate, Iohn McCain.

'1. Ray Fair Predicting Presidentlal Elections and 1ther Tltings (stanford, Calif.; Stanford University Press, 2002).

g

Potential output

CHAPTER rp, i:iscalPaiic't 777

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Another Yale economist,William Nordhaus, devel-

oped a theory of poiiiical bnciness eycles, arguing that incumbent presidents, during an election year, use expansionary policies to stimulate the economy, often only temporarily. For example, evidence sug- gests that President Nixon used expansionary policies to increase his chances for reelection in 1972, even pressuring the Federal Reserve chairman to pursue an expansionary monetary policy.

The evidence to support the theory of political business cycles is not entirely convincing. Read more details about fiscal policy and elections in this chap- ter's case study on 4ltrpress.cengage.com,/econ.

fl-ags Ern FEseeE

The time required to approve and implement fiscal legislation may hamper its effectiveness and weaken discretionary fiscal poiiry as a tool of macroeconomic stabiiization. Even if a fiscal prescription is appropri- ate for the economy at the time it is proposed, the

months and sometimes years required to approve and

implement legislation means the medicine couid do more harm than good. The policy might kick in oniy after the economy has already turned itself around. Because a recession is not usuaily identified until at

least six months after it begins, and because the ro recessions between 1945 and zoor lasted only ro months on average,

discretionary fisca1 policY allows little room for error (more later about timing problems).

DiscretisffiaE"Se FiseaB Fof;Eey end

Permam*ffi€ $ffi€effi?€ It was once believed that

discretionary fi scal pol- icy couid be turned on and off like a water faucet, stimulating or dampening the economy at the right time by just the right amount.

Given the marginal

r.r ProPenslty to con- 1r i ,:r, sume, tax changesrl'. r could increase

,:t or decrease dis- posable income to bring about

desired change in consumption' A more recent viev suggests that people base their consumption deci sions not mereiy on changes in their current incom' but on changes in their permanent income.

P€rmanent incame is the income a persol expects to receive on average over the long terrn Changing tax rates does not affect consumptior much if people view the changes as only temporarJ In t967, for exampie, the escalating war in Vietnan increased military spending, pushing real GDI beyond its potential. The combination of a boom' ing domestic economy and higher defense spending opened up an expansionary gap by 1968. That year Congress approved a temporary tax hike. The higher tax rates were scheduied to last only 18 months Higher taxes were supposed to soak up some dispos- able income to reiieve inflationary pressure in the economy. But the reduction in aggregate demand turned out to be disappointingly smail, and inflation was hardly affected. The temporary nature of the tax increase meant that consumers faced only a smal)

cu r'Iir fieti *pretrrtatrYtn*rirtccnta Dkta'uss'Ite?rna1le{n* income changed little, consumption changed little. Consumers simply saved less. As another exampie, in late t9g7,)apanese officials introduced an income tax cut intended to stimulate Japan's flat economy. People expected the cut would be repealed after a year, so economists were skeptical that the plan would work, and it didn't. Likewise, the stimulative effects of the $6oo per family tax rebates in zoo8 were disappointing. In short, tothe extentthatconsum' ers base spending decisions on their permanent income, attempts to flne-tune the economy with temporary tax changes are less efJective.

The Feedbask Hffeets cf Fiseal Fofiiey #m Aggresate SUPPIY So far we have limited the discussion of fiscal policy to its effect on aggregate demand. Fiscal poiiry may aiso affect aggegate supply, although this is usually unintentionai. For exampie, suppose the government increases unemployment benefits, paid with higher taxes on earnings. If the marginal propensiry to con- sume is the same for both groups, the increased spending by beneficiaries just offsets the reduced spending by workers. There would be no change in aggregate demand and thus no change in equilib- rium real GDP, simply a redistribution of disposabie income from the employed to the unemployed.

But could the program affect labor supply? Higher unempioyment benefits reduce the opportunity cost of not working, so some job seekers may decide to search at a more leisurely pace. Meanwhiie, higher tax rates reduce the opportunity cost of leisure, so

PofrF*y

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permanent income i:tecme that individuais expeet to re**is* sn gverage cvsr the lili:E term

17A PART 3 i:isrirl ;inc li'l*::r:taiv Polc-i

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