Long Run Effects of Fiscal Policy - Video Tutorials & Practice Problems
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Persistent Budget Deficit
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Alright now, let's see some of the long run effects of fiscal policy. So, let's start with the first situation, which is one that we kind of see happening in the US right now is a persistent government budget deficit, that means that the tax revenues, the money they're bringing in is less than their spending. Okay. So they're spending more than they are bringing in revenue. They have a budget deficit. So how are they going to pay for this deficit is by borrowing funds, right? Just like anyone, uh when you, when you need money, you're gonna borrow it to to make up your debts. So when the government needs to borrow money, we have what's called the crowding out effect. Okay, this is this is one of those buzzwords that they love to use is the crowding out effect. And this is where the government is competing with firms for low nable funds and that's gonna drive up the intro. So it's kind of follow, let's see how this leads to higher interest rates when the budget, when there's a budget deficit. Well, the government is going to be borrowing money, right? The government's gonna be borrowing money, meaning there's more demand for money driving up the price of money, which is interest, right? So when the government is borrowing, there's more people trying to borrow. There's not just firms trying to borrow money right now. Now there's also government trying to borrow money and they're going to fight for those low nable dollars driving the price up. So with that interest rate higher. Well now, at a higher interest rate, there's gonna be less investment spending, right? Because investors want to have a low interest rate when they're going to invest in long term things like factories and equipment, whatever they're gonna build, they want to have a lower interest rate to have higher profit. So the higher the interest rate goes to lower the investment spending is gonna go, which leads to lower long run growth, right? Because if there's no investment spending, no factories being built, no equipment, no buildings being built. Well, those are the things that we need those investments, those capital investments for long term growth. So this budget deficit has long term implications on our GDP, right? Our long term growth, our long run growth of our economy is stunted by having a budget deficit. So the debt leads to interest payments. And that's going to put pressure on future budgets, right? The more money you borrow now, well, that's the more interest you're gonna have to pay off later. So in further in, in further years, we're gonna have to be even more conservative with our spending because of all of these interest payments. So in the in future years, the government's gonna have to increase taxes or cut spending to pay off the debt. Right? They're gonna have to be more conservative in the future. Now, the government should try to balance extra spending during recessions with surpluses during expansions, right? So when they're when they're in a recession, maybe they should increase their spending and then in an expansion maybe they should pull it back. Does this actually happen? Not really. Right. Even though they boost up their spending during a recession a lot of times, it's hard to take back that spending. Okay. Sometimes once that's once those wheels are in motion, it's hard to kind of stop the train of government spending from going. So it doesn't really happen that they balance out when they spend a lot with times where the economy is good and spend less. Okay, so that's really what happens with the persistent government deficit a budget deficit? Is this crowding out effect leads to stunted long run growth. Okay, let's pause here and let's talk about long run tax policy in the next video. Yeah.
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Long Run Tax Policy
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So another effect of government policy of our fiscal policy is the long run tax policy. We use this idea of a tax wedge, and this is the difference between pre tax and post tax. So the difference between pre tax and post tax income. So let's say you earn $20 an hour, but our tax 25% so 25% of that is going to taxes, that means you're paying $5 of that wage and taxes, right? So you're gonna have $15 of income post tax. And there's this $5 tax wedge, that's what we call the tax wedge, is the difference between what you earned, gross that $20 an hour you are earning and what you actually have left after taxes $15. So you can imagine that the long run effects of Fisk of tax policy are gonna have effects on the economy as well. So the first one, we'll talk about lower the lower the taxes go, how that affects the economy. Um But it's the opposite for higher taxes. The lower the individual taxes go, well, there's more disposable income leading to more consumption, right? Just like we've talked about um pretty consistently throughout this quote, of course, the lower the taxes go, well, the more income you have, the more you can consume, and it's the same for for corporate taxes, because corporate taxes is the same for firms, when there's lower, lower corporate taxes, well then they're gonna have higher returns leading to more investment, right? So when there's uh lower taxes, it leads to higher investment as well. Lower taxes also help on capital gains and dividends. So they increase the supply of low nable funds. When there's lower taxes, there's an increase in the supply of low noble funds. Because this is savings from households, households are more likely to save when there's lower taxes, right? If there's lower taxes on their earnings from savings, because remember if you earn any money from the savings, well, you're going to be taxed on that. So the lower those taxes go, the more incentive you have to save. And when there's an increase in that supply of low noble funds, it's gonna lower the interest rate, it will lower the interest rate as well. So, there's benefits here too long run sustained lower tax policy, however, that needs to be balanced in a balanced budget. Remember a budget deficit? The lower the taxes go while spending has got to come down to right to keep that balanced budget. So, these are the effects that we'll see from long run tax policy here. Alright, let's go ahead and pause and we'll move on to the next video. Yeah.
