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