|5. Fiscal Policy Effects under Alternative Assumptions about Monetary Policy|
A good way to learn about the properties of a model (and if the model is any good about the properties of the economy) is to consider the effects of changing various fiscal policy variables. We know from Chapter 2 that fiscal policy effects depend on what is assumed about monetary policy, and so we must also consider monetary policy in this chapter. We begin with a very straightforward experiment: a decrease in government purchases of goods with the interest rate reaction function used. Federal government purchases of goods in the model is denoted COG. COG is to be decreased with equation 30 used.
|5.1 Changes in Government Purchases of Goods|
Experiment 5.1: Decrease in Government Spending, Interest Rate Reaction Function
The following are some of the questions you should consider about this experiment, but they are by no means exhaustive. You should add to the list. For most questions, you should focus on the results about four quarters out. After four quarters the economy has adjusted enough to the government spending change for the effects to be noticeable.
The second experiment is the same as the first except that the interest rate, RS, is taken to be exogenous.
Experiment 5.2: Decrease in Government Spending, Interest Rate Unchanged
The experiments so far have been for a permanent change in government purchases of goods. The next experiment examines the effects of a temporary change. This experiment is the same as Experiment 5.1 except that the change in COG is only for the first quarter.
Experiment 5.3: Temporary Decrease in Government Spending, Interest Rate Reaction Function
|5.2 Other Fiscal Policy Variables|
|We now turn to other tools of fiscal policy. For the rest of the
this chapter we will use the interest rate reaction function as our
monetary policy. Keep in mind, however, that somewhat different results
would be obtained
if instead we took RS to be exogenous.
Say that instead of cutting government spending COG by $20 billion, you wanted to raise personal income taxes by approximately the equivalent amount. How do you do this? The federal personal income tax rate in the model is D1G, and so D1G needs to be raised. Say that we want D1G to be raised so that the initial impact of the tax increase takes about the same amount away from the economy as the decrease in COG did. COG is in real terms and tax payments are in nominal terms, and so the first thing we need to do is to convert the $20 billion decrease in COG into nominal terms. PG in the model is the price index for COG, and its value in 2011:2 was 1.144. The nominal change in government spending corresponding to a $20 billion real change is thus $20 billion times 1.144 = $22 billion. We thus need to raise taxes by $22 billion.
The level of federal personal income taxes in the model (THG) is
You should be aware that calculations like we have just done are rough. You cannot change D1G to hit a particular change in THG exactly because YT is endogenous. As D1G is changed, the economy changes, including YT, and so THG will also change for this reason as well as from the initial change in D1G. Calculations like the above give one a fairly good idea where to start, but it may be after the first run that you want to adjust D1G slightly to meet more accurately the THG target.
Experiment 5.4: Increase in the Personal Income Tax Rate, Interest Rate Reaction Function
Another important fiscal policy variable is TRGHQ, the level of transfer payments from the federal government to households. TRGHQ is in real terms. Say that instead of increasing the personal tax rate to raise approximately $20 billion in real terms, the government wanted to decrease TRGHQ by $20 billion. The experiment is:
Experiment 5.5: Decrease in Transfer Payments, Interest Rate Reaction Function
There are other fiscal policy variables that can be changed, which you may want to do as additional assignments. The following are additional changes that can be made.
Changes in the Profit Tax Rate D2G
WARNING: Please read Section 2.4 under the heading "Tax Rate Effects" regarding the likely effects of changing D2G. Changing D2G may not be a sensible thing to do.
Federal corporate profit taxes (TFG) is determined in equation 49:
Changes in the Indirect Business Tax Rate D3G
The level of federal indirect business taxes (IBTG) is determined by
Changes in the Social Security Tax Rates D4G and D5G
The level of employee social insurance contributions to the federal
(SIHG) is determined by equation 53, and the level of employer social
contributions to the federal government (SIFG) is determined by equation
Changes in the Number of Military Jobs JM
JM is the number of federal military jobs (in millions of jobs). From equation 104 (see Table A.3 in the appendix), each job costs the government WM*HM, where WM is the wage rate per hour (divided by 1000) and HM is the number of hours worked per job in the quarter (which for military jobs is always taken to be 520 hours). In 2011:2 the value of WM was $.0871 and as just noted the value of HM was 520. If, say, you want to decrease JM to correspond to a decrease in government spending of $22 billion at an annual rate, this is a decrease in JM of (22/4)/(.0871*520) = .121 million jobs.
Changes in the Number of Federal Government Civilian Jobs JG
Similar considerations apply to the number of civilian jobs JG. From equation 104, the cost of a civilian job to the government is WG*HG, where WG is the wage rate per hour (divided by 1000) and HG is the number of hours worked per job in the quarter. In 2011:2 the value of WG was $.0585 and the value of HG was 461.9. If you want to decrease JG to correspond to a decrease in government spending of $22 billion at an annual rate, this is a decrease in JG of (22/4)/(.0585*461.9) = .204 million jobs.
Change in Grants in Aid to State and Local Governments TRGSQ
TRGSQ is the level of grants in aid to state and local governments from the federal government. It is in real terms, and you can change it like TRGHQ was changed in Experiment 5.5. Remember, however, that any change in TRGSQ is likely to change state and local government behavior. If you increase TRGSQ, state and local governments are likely to spend more or tax less, and if you decrease TRGSQ, they are likely to spend less or tax more. You should thus change some state and local government variable along with TRGSQ in order for the experiment to be sensible.
A Note on Being Sensible
You should be aware that large, rapid changes in government policy variables are not realistic. It takes time for the government to put policy changes into effect, and the political process is such that large changes are seldom done. Also, if you make large changes in policy variables, the results from the model are less trustworthy than if you make small changes. Changes in policy variable that are outside the range of past changes means that you are analyzing events that are historically unprecedented, and since models are estimated over historical data, they may not capture the effects of extreme events well. So don't go wild with the policy variables.