Long-Run Implications on Fiscal & Monetary Policy.
-
Upload
carmel-montgomery -
Category
Documents
-
view
222 -
download
0
Transcript of Long-Run Implications on Fiscal & Monetary Policy.
Long-Run Implications on
Fiscal & Monetary Policy
Let’s answer some common questions about the future of our
nation’s economy…1. If my family has to pay off its debt, why shouldn’t the government be forced to pay off its debt?
2. Wouldn’t the easy solution be to create a Constitutional amendment that would require the government to have a balanced budget each year?
3. So what’s the problem with the government being in debt? It’s not like we are actually going to fall off a “fiscal cliff!”
4. If we keep spending like we are we are going to bankrupt our grandchildren. Why are we just kicking our debt down the road?
5. Why don’t we just get rid of Social Security? That would get rid of the deficit.
6. If we are in control of the money supply, why don’t we just print enough money to pay it all off?
1. If my family has to pay off its debt, why
shouldn’t the government be
forced to pay off its debt?
2. Wouldn’t the easy solution be to create
a Constitutional amendment that
would require the government to have a balanced budget
each year?
Fiscal Policy and the Budget Balance
• Budget Balance=savings or dissavings of government
SGovernment = T – G – TR
• Expansionary policies reduce the budget balance (-)
• Contractionary policies increase the budget balance (+)
• However, budget balance is not the result of discretionary fiscal policy alone…often times it is non-discretionary fiscal policy that guides our budget balance.
Cyclically Adjusted Budget Balance
• There is a strong relationship between the budget balance and the business cycle
• Automatic stabilizers are the greatest reason for this
• Budget tends towards surplus during expansions and deficit during recessions
• Business cycle effects on the budget balance are temporary – eliminated in the long run
• Cyclically adjusted budget balance: estimate of the budget balance if GDP = YP
• less volatile than actual budget balance
• Removes effects of business cycle
So, Should the Budget Be Balanced Annually or Cyclically (on average)?
• Economists believe the budget should be balanced on average
• deficits in bad years offset by surpluses in good ones
3. So what’s the problem with the
government being in debt? It’s not like we are actually going to fall off a “fiscal cliff!”
Problems posed by Government Debt
1. “Crowding out”
2. Interest payments put financial pressure on future budget
4. If we keep spending like we are
we are going to bankrupt our
grandchildren. Why are we just kicking our debt down the
road?
Deficits, Debt, & Implicit Liabilities
• To assess the ability of governments to pay their debt, we use the debt-GDP ratio, the government’s debt as percentage of GDP
• As long as GDP outpaces debt, there is no concern about government’s ability to pay off that debt
• Implicit liabilities are spending promises made by the government that are effectively a debt, though not included in current debt statistics
• The largest are Social Security & Medicare
• Cause the greatest concern about future debt & ability to pay
5. Why don’t we just get rid of Social
Security? That would get rid of the
deficit.
6. If we are in control of the money supply, why don’t we
just print enough money to pay it all
off?
Monetary Policy in Practice
• Expansionary in times of negative output gap
• Contractionary in times of positive (inflationary) gap
• Taylor rule for setting federal funds rate takes into account both inflation and output gap
FFR = 1% + (1.5 X inflation rate) + (0.5 X output gap %)
• Fairly accurate predictor of Fed actions, though the fed funds rate can’t be negative even when there is a large negative output gap
Monetary Policy and the Long Run
• Self-correcting economy means that demand shocks caused by monetary policy only have temporary effects
Shift in AD as a result of money supply increase
New output above YP, so wages rise
Decrease in output in response to rising cost of inputs (AS shift)
Return to equilibrium output, but at higher price level
(Opposite effect for contractionary policy)
Monetary Neutrality
• Monetary neutrality means that changes in the money supply have no real effect on the economy in the long run (though they have powerful effects in the short run)
• Change in price level is proportional to change in money supply
Monetary Neutrality and Interest Rate
Rise in money supply pushes down interest rate
Greater demand causes aggregate price level to rise
Raises demand for money
Return to original interest rate
Final Thoughts on Fiscal & Monetary Policy
Lags
• Fiscal policy – Greatest lag is government choosing and implementing response
• Monetary policy – Greatest lag is economy responding to policy
• Our government does not set an inflation target, though we want low – but positive – inflation