Session 11

Macro Economics
Chandrika Raghavendra
 Topics to be covered

• We will learn about:

– Fiscal policy- the best case scenario
– The limits of Fiscal policy
– Danger of Fiscal policy
– How Fiscal Policy gets offset by the actions of RBI, Businesses, and Households
 Fiscal Policy
The Best-Case Scenario
The best-case scenario for expansionary fiscal policy is when there are lots of underemployed
resources in the economy, and the government is good at identifying and targeting these resources.

We'll learn how to analyze the effects of expansionary fiscal policy using the aggregate supply and
demand model
 Fiscal Policy
The Best-Case Scenario
 All these consumers used to
visit the shopping mall to shop
Now, only a few of them visit,
as consumers become fearful
about the future, and so they
cut back on their consumption
 Assuming no other
changes in the economy, a
drop in consumption shifts
the aggregate demand
curve to the left and
down.
Real growth is
The economy is now
negative, and a
operating below its
recession is
optimal level. It's no
underway
longer growing at 3%.
 Even though the economy's growth potential is still 3% a
year, when consumers suddenly stop spending, the
economy takes time to adjust

So, the reduction in consumption creates a temporary

reduction in the real growth rate as well

Of course, in the longer run, the fear will subside, and

consumption will return to previous levels

Should Government wait for the fear to subside and AD

to return to its previous level or take some corrective
actions??
Let’s assume Govt.
chooses to increase
spending!

By increasing spending, the government can try to

counteract falling aggregate demand

or

The government could decrease taxes, hoping to increase

private consumption
An increase in government spending, will increase the
aggregate demand, or "AD" curve, to shift to the right.
 Fiscal policy has many implementation challenges

The best case for fiscal policy is during a recession caused by an aggregate demand shock

But even with this best-case scenario, it's still difficult to affect change

An ideal stimulus is -

Timely Targeted Temporary

Implications of any policy is

temporary
Let's look at each of these problems in more detail

Timely
Identify a
problem
By the time that government spending is working its way
through the economy, the situation may have changed

Legislative
lag
One way to minimize lag time is to focus on automatic stabilizers -- fiscal policy that
occurs automatically, without legislation

For example, if the economy is doing poorly, income, capital

gains, and corporate profits fall. Our progressive tax code
could even mean lower tax rates during tough times

And that's good because lower taxes will result in more

Timely
spending, boosting the economy

Most economists, therefore, favor automatic stabilizers

Direct taxes follow a progressive taxation system (based on income level)

while indirect taxes follow a proportional taxation system (x% irrespective of
income level) in India
 Plans road construction Schools construction

Public Sector Private Sector

Economic
Recovery

Well, an ideal stimulus would quickly hire unemployed workers, putting them to work
on projects, which were completed as the economy recovers
What do we mean? This is ideal because an unemployed worker has a low opportunity cost -- so that's
the best time to hire
 Plans road construction Schools construction

Public Sector Private Sector

Cost to
Society

If instead, the government hires a worker who would have had a job anyway, the cost to society is much greater
Let's look at each of these problems in more detail
Ideally, we would want Govt. to hire unemployed workers,
but that isn't always possible

Corona virus outbreak raised unemployment by 14.7%

in April 2020 and job losses reached 20.5 million

There were a total of 5.1crore construction workers in Targeted

the country, the number of unemployed in India raised to
27.11% in that period

Can Govt. start hiring all construction workers (simply without having any projects)??

NO, GOVT. CANNOT

Even among construction workers, there are big differences

A roofer, for example, who had been working home construction -- they might not have the right skills to
easily switch over to road construction

As a result, when the government spends money on a new construction project, that may mean hiring
workers away from other jobs rather than hiring unemployed workers
 Dangers of Fiscal Policy

Most economists agree that fiscal policy is useful when many

resources are underemployed due to an aggregate demand
shock, and the economy needs a short-run boost

There's less agreement when it comes to using fiscal policy to

combat shifts in aggregate supply, and over the potential
dangers of debt-financed fiscal policy
 Fiscal policy in this situation -- it's relatively powerless.

Shift in S & LRAS curve

A big increase in aggregate demand could increase real growth
somewhat but mostly at the cost of much higher inflation.
When real growth slows due to an aggregate demand But when real growth slows due to an aggregate supply
shock, the economy is operating below its potential so shock, it's the potential growth rate that has fallen.
there's more room for fiscal policy to bring the There's less inefficiency in the economy, and thus fiscal
economy back to potential policy has less power
 Fiscal policy can also be a dangerous tool when
used too much

In theory, fiscal policy is like

national consumption smoothing:
increase aggregate demand in
bad times, and pay off the bill
in good times

But in practice, politicians

spend in bad times, because
they have to -- and they spend
in good times because they
can
We're just not that great at national saving. And if a government's debt continues to grow, it'll end
up spending a larger and larger portion of its budget on interest payments alone, making it more
difficult to act in a future recession
https://economictimes.indiatimes.com/news/economy/indicators/moodys-flags-high-government-debt-and-
fiscal-slippage-risks-for-indian-economy/articleshow/100911680.cms
 Too much debt, especially when a country borrows money from another country in the other
country's currency -- this can create uncertainty, and risk, and even lead to economic collapse.

Take, for example, Argentina's financial crisis of 1999 to 2002.

 Argentina's financial crisis of 1999 to 2002

In the years leading up to the crisis,

Argentina's government was
spending and borrowing more
and more and more, making
investors and citizens a little
nervous of its ability to pay off its
debts

So, when the economy suffered a

financial crisis, and the
government tried to spend
even more to stimulate the
economy, to get out of the crisis,
citizens and investors took that as
a bad sign rather than as a
good one
Argentina's financial crisis of 1999 to 2002

In fact, citizens and investors

drastically reduced their
spending and investing -- so
much so that the country
experienced declines in real
GDP rather than growth
 Argentina's financial crisis of 1999 to 2002

In other words, consumption and investment fell by more than government spending increased --
over 100% crowding out!

By 2002, Argentina's debt was 150% of GDP, and the government defaulted on its payments.

This was the largest government default in the history of the world.
But other developing countries -- Thailand, Indonesia, and Mexico, and even Greece - - they've
experienced similar scenarios
 How Fiscal Policy gets offset??

Fiscal policy can also be fully or partially offset

depending on how central banks, businesses, and
consumers respond to fiscal policy
When increases When inflation
spending starts increasing

Expansionary Contractionary
Results in FP MP Controls Money
Increased AD Supply

Expansionary FP
offsetting through a
Increases Contractionary MP Reduces
Inflation Inflation
we call this a Monetary Offset
Borrow to increase Bec of high demand for loans, interest
spending rates increases and loans become costlier

Lesser borrowings
by Businesses and
scale back their
investments
Offsetting the fiscal stimulus
and weakening the effects of
the multiplier

Results in reduced
GDP
 Through Cutting More Disposable
Taxes Income

Prefer to Save, Households may

thinking Govt. may not spend
raise taxes next
year

No Multiplier Effect

This scenario is sometimes called RICARDIAN EQUIVALENCE

Ricardian equivalence (named after the 19th century British economist David Ricardo), is considered imperfect by
most economists, hence it failed
 Takeaways from Session 10 & 11

• You understood :
– Fiscal Policy, types and its objectives
– Fiscal Multiplier
– Role of Government Spending under expansionary and contractionary Fiscal policy
– Fiscal policy and Crowding out
– Fiscal policy- the best case scenario
– The limits of Fiscal policy
– Danger of Fiscal policy
– How Fiscal Policy gets offset by the actions of RBI, Businesses, and Households
https://www.youtube.com/watch?v=uxRXYDrEpds
 Activity

Policy Tool Expansionary Contractionary

Monetary 1. OMO Buy/Sell T-Bills Buy/Sell T-Bills
2. Repo Rate In/decrease In/decrease
3. Reserve Ratios In/decrease In/decrease

Fiscal 1. Income Tax In/decrease In/decrease

2. G-Spending In/decrease In/decrease