Y1 31) Fiscal Policy - Problems and Evaluation

Summary

This video explores the drawbacks of expansionary fiscal policy, focusing on trade-offs such as higher inflation, increased trade deficits, and worsened government finances. It highlights macroeconomic conflicts, including potential crowding out of private investment and risks of inefficient government spending. Key considerations include the size of the output gap, multiplier effects, and consumer confidence, all affecting policy effectiveness. Additionally, the video discusses long-term tax revenue gains versus short-term debt increases, along with contrasting views from Keynesian and classical economists regarding fiscal policy's role during recessions.

Takeaways

• 💡 Expansionary fiscal policy can boost aggregate demand, leading to higher economic growth and lower unemployment.
• ⚖️ However, this policy can cause trade-offs like higher inflation (demand-pull inflation) and worsening trade deficits due to increased import spending.
• 📉 Government finances may deteriorate with rising budget deficits and national debt, requiring future spending cuts or tax increases.
• 💰 Ricardian equivalence suggests that households might save tax cuts, expecting future tax hikes, which could reduce the immediate economic boost.
• 🏦 Crowding out can occur if government borrowing raises interest rates, making it harder for private businesses to invest, potentially harming long-term growth.
• ⏳ Expansionary fiscal policy can have time lags, as the effects of government spending or tax cuts might not immediately translate into economic growth.
• 📊 The effectiveness of the policy depends on the size of the output gap; it works better when there’s a larger gap and less risk of inflation.
• 🔄 The size of the multiplier matters—if large, a smaller government intervention may suffice, reducing the strain on public finances.
• 👎 Low consumer or business confidence can diminish the impact of tax cuts, as savings might increase instead of spending or investment.
• 🛠️ In recessions, Keynesians argue that expansionary fiscal policy can stimulate the private sector by creating demand, opposing the classical belief that economies will self-correct.

Q & A

What is the primary benefit of expansionary fiscal policy?

The primary benefit of expansionary fiscal policy is that it increases aggregate demand, leading to higher economic growth and lower unemployment.

What are the potential macro objective trade-offs associated with expansionary fiscal policy?

Some potential macro objective trade-offs include higher demand-pull inflation, a widened current account deficit, and worsened government finances due to increased budget deficits and national debt.

How might expansionary fiscal policy lead to higher inflation?

If aggregate demand rises significantly, it can cause demand-pull inflationary pressure, especially if the economy is near full capacity, which may lead to inflation overshooting the target.

How does expansionary fiscal policy affect a country’s trade balance?

As households' incomes rise due to economic growth, they may spend more on imports, widening the current account or trade deficit. This is known as the 'sucking in of imports' effect.

What is Ricardian equivalence, and how does it relate to expansionary fiscal policy?

Ricardian equivalence is the theory that households might save tax cuts instead of spending them, anticipating future tax increases to pay for current deficits, thereby reducing the effectiveness of expansionary fiscal policy.

What is the 'crowding out' effect in the context of expansionary fiscal policy?

The 'crowding out' effect occurs when government borrowing increases demand for loanable funds, raising interest rates and making it more expensive for private businesses to borrow and invest, potentially harming long-term growth.

Why might expansionary fiscal policy result in inefficiency in government spending?

Government spending can be less efficient because governments lack a profit motive, leading to potential cost overruns or 'X-inefficiency' in infrastructure projects or other public sector spending.

How do time lags affect the effectiveness of expansionary fiscal policy?

There are significant time lags associated with both government spending on infrastructure and the effects of tax cuts, which can delay the intended boost to the economy.

Why is the size of the output gap crucial in determining the effectiveness of expansionary fiscal policy?

If the economy is close to full employment, expansionary fiscal policy is less effective and more likely to cause inflation. However, if there is a large negative output gap, it can boost growth and reduce unemployment without much inflationary pressure.

How can the size of the fiscal multiplier impact the effectiveness of expansionary fiscal policy?

A large fiscal multiplier means that government spending can generate multiple rounds of increased spending and income, amplifying the effect of fiscal policy on aggregate demand and economic growth. Conversely, a smaller multiplier may require larger government spending to achieve the desired effect.