Economics 2 Professor Christina Romer Spring 2017 Professor David - - PDF document

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Economics 2 Professor Christina Romer Spring 2017 Professor David Romer LECTURE 21 FISCAL POLICY April 11, 2017 I. R EVIEW OF THE K EYNESIAN C ROSS D IAGRAM A. Determination of output in the short run B. What causes short-run fluctuations? C.

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Economics 2 Professor Christina Romer Spring 2017 Professor David Romer LECTURE 21 FISCAL POLICY April 11, 2017 I. REVIEW OF THE KEYNESIAN CROSS DIAGRAM

  • A. Determination of output in the short run
  • B. What causes short-run fluctuations?
  • C. Another example of a shift in the expenditure line: A rise in animal spirits
  • D. Other factors that shift the expenditure line
  • II. FISCAL POLICY IN THEORY
  • A. Definitions
  • B. Example: A tax cut
  • 1. How does a tax cut affect PAE?
  • 2. Effects on output in the short run
  • C. Countercyclical fiscal policy
  • III. EMPIRICAL EVIDENCE ON THE EFFECTS OF FISCAL POLICY: DISCUSSION OF THE

ROMER AND ROMER PAPER

  • A. The difficulty in estimating the effect of tax changes on output
  • B. Romer and Romer’s approach
  • C. Empirical estimates of the macroeconomic effects of tax changes
  • D. Evaluation
  • IV. CASE STUDY: THE 2008 RECESSION AND THE FISCAL POLICY RESPONSE
  • A. Causes of the 2008 recession
  • B. Issues in designing the American Recovery and Reinvestment Act
  • C. Estimates of the effect of the Recovery Act
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SLIDE 2

LECTURE 21

Fiscal Policy

April 11, 2017

Economics 2 Christina Romer Spring 2017 David Romer

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Announcements

  • We have handed out Problem Set 5.
  • It is due at the start of lecture on Thursday,

April 13th.

  • Problem set work session today, 5:00–7:00

p.m. in 648 Evans.

  • There is a typo in Problem 3.
  • Please respect the no electronics policy!
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SLIDE 4

Revised Question 3

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SLIDE 5
  • I. REVIEW OF THE KEYNESIAN CROSS DIAGRAM
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SLIDE 6

Determination of Short-Run Output

  • Equilibrium condition:

Y = PAE

  • Output responds to demand in the short run.
  • Referred to as the 45-degree line.
  • Planned spending is a function of output:

PAE = C + Ip + G + NX

  • Where C depends on positively on Y−T.
  • Referred to as the expenditure line.
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Determination of Short-Run Output

Y PAE PAE Y=PAE Y1

Sometimes called the “Keynesian Cross” diagram.

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SLIDE 8

What Causes Short-Run Fluctuations?

  • Anything that shifts the expenditure line will cause
  • utput to change in the short run.
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SLIDE 9

Example: A Rise in Animal Spirits

  • Suppose that something causes firms throughout

the economy to raise their expectations of the future MRPK.

  • This will make firms want to do more investment.
  • This will shift up the expenditure line.
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SLIDE 10

A Rise in Animal Spirits

Y PAE1 PAE Y=PAE Y* PAE2 Y2

The rise in Y is larger than the initial increase in PAE because of the multiplier effect.

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SLIDE 11

What Shifts the Expenditure Line?

  • A change in autonomous consumption (consumer

confidence, wealth, uncertainty).

  • A change in firm’s expectations of future MRPK

(animal spirits).

  • A change in the real interest rate.
  • A change in taxes or government purchases.
  • A change in net exports.
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SLIDE 12

Two Types of Macroeconomic Policy

  • Fiscal policy: Actions taken by the government to

change the budget surplus.

  • Monetary policy: Actions taken by the central

bank to affect nominal and real interest rates.

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SLIDE 13
  • II. FISCAL POLICY IN THEORY
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SLIDE 14

Fiscal Policy Terminology

  • Government budget surplus:
  • Tax revenues − Government purchases (T−G)
  • Contractionary fiscal policy: Actions that increase

the government budget surplus.

  • Will decrease PAE at a given level of Y.
  • Expansionary fiscal policy: Actions that decrease

the government budget surplus.

  • Will increase PAE at a given level of Y.
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SLIDE 15

Federal Budget Surplus and the Bush Tax Cuts

Source: Congressional Budget Office.

  • 4
  • 3
  • 2
  • 1

1 2 3

1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

Percent of GDP

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SLIDE 16

Substituting the Consumption Function into PAE C = C + c·(Y−T) PAE = C + Ip + G + NX = C + c·(Y−T) + Ip + G + NX = C + cY – cT + Ip + G + NX = (C – cT + Ip + G + NX) + cY

PAE Intercept Term

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SLIDE 17

Short-Run Effects of a Tax Cut

Y PAE1 PAE Y=PAE Y1 PAE2 Y2 (Y*)

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Combining the Effects of a Fall in Autonomous Consumption and a Tax Cut

Y PAE1,PAE3 PAE Y=PAE Y* PAE2

PAE shifts down (to PAE2) because of the fall in autonomous consumption. PAE shifts back up (to PAE3) because of the tax cut.

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SLIDE 19

Countercyclical Fiscal Policy

  • Changes in the budget surplus (through changes in

taxes or government purchases) to try to counteract other factors likely to cause a short-run fluctuation.

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SLIDE 20
  • III. EMPIRICAL EVIDENCE ON THE EFFECTS OF FISCAL

POLICY: DISCUSSION OF THE ROMER AND ROMER PAPER

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SLIDE 21

Difficulty in Estimating the Effect of Tax Changes

  • Some tax cuts are taken because output is falling.
  • Would not expect output to rise following

these tax cuts.

  • This is an example of omitted variable bias.
  • A third variable (whatever is causing the

recession) is driving both output and tax changes.

  • Positive effects of tax cuts will be

underestimated.

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SLIDE 22

How do Romer and Romer try to deal with this difficulty?

  • Identify the motivation for the tax changes using

narrative sources.

  • Read Congressional reports, Presidential

speeches, Economic Report of the President.

  • Then limit the statistical analysis only to tax

changes not taken in response to the state of the economy.

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SLIDE 23

Exogenous Tax Changes

Source: Romer and Romer, “The Macroeconomic Effects of Tax Changes.”

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SLIDE 24
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Specification

  • ΔY is the percentage change in real GDP.
  • ΔT is the new measure of exogenous tax changes

(as a percent of GDP).

  • The regression estimates the relationship between
  • utput growth and the contemporaneous and

lagged values of tax changes.

  • We expect a negative relationship.
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SLIDE 26

Baseline Estimates

Source: Romer and Romer, “The Macroeconomic Effects of Tax Changes.”

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Evaluation

  • Do you trust the narrative sources?
  • Is narrative analysis reproducible?
  • Does this approach deal with omitted variable bias

successfully?

  • Is the empirical specification sensible?
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SLIDE 28
  • IV. CASE STUDY: THE 2008 RECESSION AND THE

FISCAL POLICY RESPONSE

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SLIDE 29

House Prices, 1987–2015

Source: Federal Reserve Bank of St. Louis, FRED.

50 100 150 200 250

Jan-87 Jan-89 Jan-91 Jan-93 Jan-95 Jan-97 Jan-99 Jan-01 Jan-03 Jan-05 Jan-07 Jan-09 Jan-11 Jan-13 Jan-15

Case-Shiller House Price Index, January 2000 = 100

April 2006

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SLIDE 30

Effects of the Housing Bubble

  • Increased both Ip and C, so raised PAE relative to

what it otherwise would have been.

  • Some debate among economists about whether

this increase in PAE counteracted other forces lowering PAE, or pushed Y above Y*.

  • Large increase in household debt.
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SLIDE 31

U.S. Household Debt

Source: Mian and Sufi, “Consumers and the Economy, Part II: Household Debt and the Weak U.S. Recovery.”

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SLIDE 32

What happened when the bubble burst?

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SLIDE 33

Single-Family Housing Starts

Source: Economic Report of the President, February 2010.

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SLIDE 34

Source: http://www.housingviews.com.

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SLIDE 35

Credit Spreads during the Financial Crisis

Source: Economic Report of the President, February 2010.

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SLIDE 36

Stock Prices during the Financial Crisis

Source: Economic Report of the President, February 2010.

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SLIDE 37

What happened to PAE in 2008?

  • Decline in investment (particularly in housing)
  • Housing bust reduced expected future MRPK
  • f housing (which is a kind of capital).
  • Financial crisis hurt animal spirits and made it

hard for firms to get credit.

  • Decline in consumption
  • Housing bust and stock market decline

destroyed wealth.

  • Financial crisis hurt consumer confidence and

made it hard for households to get credit.

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SLIDE 38

Effect of the Housing Bust and the Financial Crisis on Output

Y PAE1 PAE Y=PAE Y* PAE2 Y2

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SLIDE 39

Percentage Change in Real GDP

Source: Federal Reserve Bank of St. Louis, FRED

  • 10.0
  • 8.0
  • 6.0
  • 4.0
  • 2.0

0.0 2.0 4.0 6.0 8.0 10.0

2000-I 2001-I 2002-I 2003-I 2004-I 2005-I 2006-I 2007-I 2008-I 2009-I 2010-I 2011-I 2012-I 2013-I 2014-I 2015-I

Percent Change (at an Annual Rate)

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SLIDE 40

Issues in Designing the 2009 Fiscal Stimulus

  • How big should it be?
  • Need an estimate of how much PAE has

shifted down.

  • Or, alternatively, how much Y would fall (and

unemployment would rise) as a result of the decline in PAE.

  • Forecasts were much too optimistic early in

the recession.

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SLIDE 41

Issues in Designing the 2009 Fiscal Stimulus

  • What should the composition be?
  • Different types of stimulus have different

effects on PAE.

  • $100 billion increase in G will increase PAE by

$100 billion; $100 billion of tax cuts will increase PAE by MPC·$100 billion.

  • Different types of stimulus affect the

economy with different speeds.

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SLIDE 42

Fiscal Stimulus in the Recovery Act through August 2009

Source: CEA, “The Economic Impact of the ARRA of 2009, First Quarterly Report.”

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Issues in Designing the 2009 Fiscal Stimulus

  • How long should it last?
  • Need a forecast of how long PAE will be

depressed.

  • If PAE will be low for more than a year, fiscal

stimulus needs to last for more than a year as well.

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SLIDE 44

Effect of the Recovery Act on Output

Y PAE1 PAE Y=PAE Y* PAE2 Y2 PAE3 Y3

PAE shifts down (to PAE2) because of the housing bust and financial crisis. PAE shifts part way back (to PAE3) because of the expansionary fiscal policy.

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SLIDE 45

Estimates of the Impact of the Recovery Act

Source: CBO, “Estimated Impact of the American Recovery and Reinvestment Act

  • n Employment and Economic Output,” February 2011.
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SLIDE 46

Midterm 2

  • Median: 77.0
  • 75th Percentile: 84.0
  • 25th Percentile: 68.0