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Final Lecture: Fiscal Policy C.L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008 1 This week Final Topic: Fiscal Policy Chapter 17, texbook (C) Red Hill Capital Corp., Delaware, USA 2008 2 Learning objectives Explain the nature and operation of both ‘discretionary’ and ‘supply-side’ fiscal policy Explain the concepts of the ‘balanced budget multiplier’ and ‘automatic stabilizers’ Discuss the importance of a government’s budget for macroeconomic performance. (C) Red Hill Capital Corp., Delaware, USA 2008 3 Previously We started the course talking about an economy’s PPF, the maximum efficient set of economic output that an economy can have. Then, we looked at markets and discovered how psychology goes into making up the supply and demand schedules for any individual good or service (G&S). Next, we saw how people are selfinterested but economy thinks of them as enlightened self-interested. (C) Red Hill Capital Corp., Delaware, USA 2008 4 Previously We discovered, though, that self-interest, like profit making or money keeping, can lead to market imperfections. One, self-interest in profits can lead to pollution for everyone. Self-interest in wanting a free ride can mean that suppliers are not getting paid what they are truly due. Thus, the government found its first place for intervention. The answers are taxes/subsidies or regulation. (C) Red Hill Capital Corp., Delaware, USA 2008 5 Previously The government also taxes things that it thinks are bad, like alcohol, cigarettes, and gasoline. We, then, looked at the overall economy, again, and defined broad variables, culminating on looking at AD-AS in the aggregate economic macro market. The government is involved in the macro picture, from the start, because it actually prints the money that is used for the transactions in the economy and controls the banking system who manage and create some of the money (so, it needs monetary policy). (C) Red Hill Capital Corp., Delaware, USA 2008 6 Previously Then, since the government is involved in the money supply, it is necessary that it have monetary policy for managing the supply and the growth of supply of the money because those variables will interact with prices for money and also for goods and services: interest rates and inflation. Moreover, since money is needed to transact business, the amount of money in the economic system can affect the final outcome of activity, real GDP. (C) Red Hill Capital Corp., Delaware, USA 2008 7 Previously The government also found another “in” to involvement in the economy, in Keynesian economics: that is the fiscal policy, the government spending and taxation, means by which a government can become involved in helping the economy, a notion that was thought to be unnecessary in classical economics. In this last lecture, we take a closer look at the fiscal policy affects on the economy. (C) Red Hill Capital Corp., Delaware, USA 2008 8 Intro Governments have a role in the economy. They have to provide public goods and services that free riders would not pay for otherwise. There are things, like protection from enemies of all sorts from outside the country and within, right down to the person that you buy your food and housing from: you wouldn’t want them to cheat you or take advantage of you. It might even have health and retirement plans for its citizens. (C) Red Hill Capital Corp., Delaware, USA 2008 9 Intro This gives government an initial raison d’etre (reason for being), and the next step is to collect revenues, in the form of taxes, to support its spending. Its spending is also part of the economy. It pays people to act as protectors, like policemen, soldiers, and consumer and financial advocates and watchdogs. (C) Red Hill Capital Corp., Delaware, USA 2008 10 Intro It buys goods and services to build highways and other country infrastructures. Thus, the government can spend money in such a way as to have an affect on the economy. It can also affect it with taxes. Then, that affect can be magnified (multiplier effect) because those people getting money to do things for the government spend their money on other things in the economy, and from an acorn springs an oak. (C) Red Hill Capital Corp., Delaware, USA 2008 11 Discretionary Fiscal Policy (C) Red Hill Capital Corp., Delaware, USA 2008 12 Discretionary Fiscal Policy Previously, we discussed Keynes theory that the economy sometimes needs to be kick-started through the initiation of government spending to stimulate economic activity and psychological attitudes of business and consumers. That was the birth of so-called discretionary fiscal policy. (C) Red Hill Capital Corp., Delaware, USA 2008 13 Discretionary Fiscal Policy Today, discretionary fiscal policy is meant to describe the deliberate use of government spending and taxation to alter aggregate demand to stabilize an economy in some sort of desirable way. In the next slide, we show the 2 directions fiscal policy can turn: expansionary or contractionary. (C) Red Hill Capital Corp., Delaware, USA 2008 14 Routes in 2 directions of discretion Expansionary Contractionary Increase government spending Decrease government spending Decrease taxes Increase taxes Increase spending and decrease taxes Decrease spending and increase taxes Increase spending and taxes, equally* Decrease spending and taxes, equally* *Relates to balanced budget multiplier: see below. (C) Red Hill Capital Corp., Delaware, USA 2008 15 Graphical Economy: AD-AS Assume graphical AD-AS curves for the analysis Simplistically, we use straight lines. Full employment is at real GDP $520 billion. Causal Chain Price level AD2 AS Increase In G 155 Increase In AD curve Increase in Price level & Real GDP E2 E1 X 150 AD1 Full Employment Real GDP ($ bil.) $500 $520 $540 (C) Red Hill Capital Corp., Delaware, USA 2008 16 Increase spending to fight recession Assume the economy has entered recession and is at E1, in the AD-AS graph shown in the slide, at real GDP = $500 billion, below the full employment level, and price level =150 on the CPI. Even though the economy is operating above the horizontal AS Keynesian range, the government can still act to stimulate the economy, trying to push it to full employment, although with higher prices, shifting AD1 to AD2. (C) Red Hill Capital Corp., Delaware, USA 2008 17 Increase spending to fight recession Recall that a shift in private demand, from C, I, or (X – M), could also do the job, but these are not within the government control. However, G is. There is always a long list of government spending proposals for roadways, health car, environmental, education, etc. Thus, there is government demand just waiting to happen. Given that fact, the government can initiate spending to increase employment, in the short-run. (C) Red Hill Capital Corp., Delaware, USA 2008 18 Increase spending to fight recession The question becomes, just how much spending does the government have to do? Whatever spending in G, it will seep through the economy and affect C and, perhaps, I. The money to those, directly from increased G, will be partly spent, which will be income for a new group of people, which will get partly spent, again, an so on. That is the spending multiplier effect. (C) Red Hill Capital Corp., Delaware, USA 2008 19 Increase spending to fight recession The spending multiplier will depend on the MPC of the recipients. We shall take a closer look at how that works. Suppose for example, that the initial spending was $10 billion and that MPC of recipients is 0.75: 75% of new income is spent on consumption. The eventual result after all of the rounds of re-spending will be that AD is pushed out by $40 billion to X. Lets look at the process in more detail. (C) Red Hill Capital Corp., Delaware, USA 2008 20 Increase spending to fight recession First, $10 bil. gets spent in G, then 0.75x$10 bil. gets spent in the next round, 0.75x0.75x$10 bil. gets spent in the next, and so on and so on. We can summarize this as Total spending approaches G + MPC G + MPC2 G + MPC3G + … = G Multiplier = n=0∞ MPCnG, the sum of powers of MPC from 0 to infinity times G. (C) Red Hill Capital Corp., Delaware, USA 2008 21 Increase spending to fight recession The equation, even though it is an infinite sum, it actually has a simple solution: Total Spending = G x 1/(1 – MPC) = G/MPS. Thus, the multiplier is equal to 1/MPS, in this case, 1/0.25 = 4, so Total spending = G x 4 = $40 billion. Pushing the AD curve out to the new one, AD2. (C) Red Hill Capital Corp., Delaware, USA 2008 22 Increase spending to fight recession The new AD curve, then, intersects the old AS at a new equilibrium point, E2. The result is that full employment is achieved and real GDP rises, but the increased demand of $40 billion does not translate into that much of a rise of real GDP: (C) Red Hill Capital Corp., Delaware, USA 2008 23 Increase spending to fight recession GDP rises by only $20 billion but demand pull inflation increased the price level from 150 to 155, a rise of about 3%. Thus, we conclude that in the neoclassical region of AS, increased government spending does not result in the theoretical maximum rise in output, G/MPS. It is less and there is also inflation. (C) Red Hill Capital Corp., Delaware, USA 2008 24 Tax cut to battle recession Another fiscal policy tool to combat recession is cutting taxes. Suppose that the government enacts a $10 billion personal tax cut. Thus, instead of increasing spending by $10 billion, like in the first example, the government decreases it revenues by the same $10 billion. The result is an increase of $10 billion in personal disposable income, DI. (C) Red Hill Capital Corp., Delaware, USA 2008 25 Tax cut to battle recession That results in a first round of spending of MPCDI = 0.75$10 billion = $7.5 billion, still assuming that MPC=0.75. Then, that money gets multiplied trough spending rounds. It is important to note, then, that a tax results in a smaller stimulus to overall AD than the same sized increase in government spending. (C) Red Hill Capital Corp., Delaware, USA 2008 26 Tax cut to battle recession We can use the same equation as in the previous example to get an equation for the theoretical maximum increase in AD as increase in AD = MPC Tax cut/MPS = $30 billion, since MPC Tax is the 1st round. We point out that an increase in welfare payments, for example, would also result in stimulus similar to that of a tax cut. However, we also point out that welfare recipients are lower income people, so they would probably have higher than average MPC’s. (C) Red Hill Capital Corp., Delaware, USA 2008 27 Fiscal policy to fight inflation If expansionary fiscal policy can fight recession, then, perhaps contractionary fiscal policy can fight inflation, particularly, demand pull inflation. Now, we assume that the economy is in the classical range of AS, as shown in the figure in a subsequent slide, operating at full-employment real output of $520 billion at a price index level of 160. In that situation, any increase in AD will result only in higher prices, no change in output. (C) Red Hill Capital Corp., Delaware, USA 2008 28 Fiscal policy to fight inflation Thus, suppose that the government uses fiscal policy to try to reduce the price level because it wants to reduce inflation in the economy. One way to go about that would be to reduce government spending. If the government cuts spending by $5 billion, the multiplier effect will result in decreased overall AD of $5 billion/MPS = $20 billion. (C) Red Hill Capital Corp., Delaware, USA 2008 29 Fiscal policy to fight inflation Then, as shown in the figure, the AD curve shifts left by a horizontal distance of $20 billion. There will be a temporary excess supply by $20 billion resulting in pressure on firms to reduce prices, and a new intersection equilibrium will be established at E2, with the same output but a decrease in the price level from 160 to 155. (C) Red Hill Capital Corp., Delaware, USA 2008 30 Fiscal policy to fight inflation We must point out that, while in theory the price level would be reduced, that would rarely happen in reality. The actual outcome would likely manifest as a reduction in the rate of inflation, rather than an actual drop in prices. The important thing is that by using either tightened monetary policy or contractionary fiscal policy, the government can try to reduce inflation in an economy. (C) Red Hill Capital Corp., Delaware, USA 2008 31 Fiscal policy to fight inflation Just like in the previous example of expansionary fiscal policy, an alternative to cutting G would be raising taxes, although that solution would be politically unpopular, but we can look at the mechanism, at least. Therefore, suppose that the government wants to reduce AD by $20 billion by increasing taxes. We can take a lesson from our previous tax reduction example. (C) Red Hill Capital Corp., Delaware, USA 2008 32 Fiscal policy to fight inflation To raise AD by $20 billion, we learned that the government would have to decrease taxes by $6.67 billion (=MPCDI/MPS), so to decrease AD by $20 billion, it would have to increase taxes by the same $6.67 billion. Although, theoretically, a government could use fiscal policy to try to combat inflation, these days, in practice, controlling inflation is done with monetary policy through the central bank. (C) Red Hill Capital Corp., Delaware, USA 2008 33 Graphical Economy: AD-AS Full employment is at real GDP $520 billion. We begin up the vertical line with demand pull inflation already in place. Causal Chain Decrease in G Or Increase d taxes Decrease In AD curve Price level AD1 160 155 AS E2 E1 AD2 Decrease in Price level (C) Red Hill Capital Delaware, USA Real GDPCorp., ($ bil.) $500 2008 $520 $540 Full Employment 34 Automatic Policy (C) Red Hill Capital Corp., Delaware, USA 2008 35 Balanced budget multiplier In our discussion of discretionary Keynesian fiscal policy, the government uses either spending or taxes to fight recession or inflation. However, using one or the other, spending or taxes, will produce an imbalance in the government's budget, revenues versus spending. An approach to fiscal policy that has gained support in the 1980’s and 1990’s is a balanced budget approach that matches any new spending with new taxes, so that there is a neutralizing affect on government financing. (C) Red Hill Capital Corp., Delaware, USA 2008 36 Balanced budget multiplier To understand the affect of this brand of policy, we must introduce the concept of the balance budget multiplier. We examined changes both changes in taxes and spending and found that the separate spending multipliers depended on MPC. We can even look at the effect in terms of the separate multipliers with G = – T = X. (C) Red Hill Capital Corp., Delaware, USA 2008 37 Balanced budget multiplier Then, AD = X/MPS – XMPC/MPS) = X(1 – MPC)/MPS = XMPS/MPS = X. Thus, identically, the balanced budget multiplier = 1, no matter what MPC is. Thus, a balanced budget fiscal expansionary increase or decrease in spending will result in a equal change in AD, e.g., G = AD. (C) Red Hill Capital Corp., Delaware, USA 2008 38 Automatic stabilizers In contrast to discretionary fiscal policy, the automatic stabilizer approach is a programmed approach that automatically adjusts over the course of the business cycle to fight both inflation and unemployment. In this approach, spending and taxes automatically change over the business cycle, in such a manner as to stabilize expansions and contractions in economic activity. (C) Red Hill Capital Corp., Delaware, USA 2008 39 Automatic stabilizers G = government spending, including transfer payments, like unemployment benefits and other social welfare payments. It decreases as Real GDP rises. G is inversely related to real GDP. That inverse relationship is meant to counteract some of the effects of changes in output. (C) Red Hill Capital Corp., Delaware, USA 2008 40 Automatic stabilizers When the economy contracts, there is more of a need for unemployment benefits and welfare and other spending to stimulate the economy, and vice versa. On the tax side, as the economy expands, people and businesses make more money, and they, necessarily, will pay more taxes. T is direct. We look at the situation, graphically, in the next slide. (C) Red Hill Capital Corp., Delaware, USA 2008 41 Automatic stabilizers, graphically G & T $ billion The balanced budget (G=T) equilibrium GDP is $500 billion. Then, look at changes in GDP. Balanced Budget $110 $100 Budget Surplus Budget Deficit $90 $470 $500 (C) Red Hill Capital Corp., Delaware, USA 2008 $530 Real GDP $ billion 42 Automatic stabilizers: causal chains Real GDP Increases Tax revenues rise & transfer payments fall Budget Offsets Inflation Real GDP Decreases Tax revenues fall & Transfer increase Budget Offsets Recession (C) Red Hill Capital Corp., Delaware, USA 2008 43 Example analysis Suppose the equilibrium balanced budget real GDP starts out at $500 billion. Next, imagine that increased consumer optimism has resulted in increased consumer spending, which ultimately results in a new level of real GDP at $530 billion. As a result, government tax revenues increase to $110 billion due to greater business activity, while expenditures reduce to $90 billion. (C) Red Hill Capital Corp., Delaware, USA 2008 44 Example analysis Thus, the government has a budget surplus: revenues exceed expenditures and the government makes a profit. Alternatively, assume that there is a recession and real GDP decreases to $470 billion. Then, tax revenues will decrease to $90 billion, while expenditures will expand to $110 billion, as more people become unemployed, for example. In this phase of the business cycle, government expenses will outstrip revenues, and the government operation will run a loss, a budget spending deficit. (C) Red Hill Capital Corp., Delaware, USA 2008 45 Auto stabilizers: leaning into the wind The beauty of automatic stabilizers is that there effect is counteractive (it leans against the prevailing wind). When the economy heats up, the government pays out less, and it takes away more from people in the economy. Thus, the effect of the stabilizers will be to moderate AD. (C) Red Hill Capital Corp., Delaware, USA 2008 46 Auto stabilizers: leaning into the wind When the economy goes into recession, tax revenues decrease and people get more transfer payments for unemployment and welfare. Thus people get more money than they would have from the economic activity, and the downdraft in the economy is offset by this extra money. (C) Red Hill Capital Corp., Delaware, USA 2008 47 Stabilizers: Some Further Notes It is nice to know that multiplier effects will act to magnify changes in, for example, government spending or taxation. However, the dependence on MPC and the assumption of infinite rounds of spending to get a compact equation in terms of MPC, means that our simple estimate will not be accurate. Alternatives to measure multipliers would be to observe cause and effect, in the markets, but, again, there would be difficulty in isolating affects. (C) Red Hill Capital Corp., Delaware, USA 2008 48 Stabilizers: Some Further Notes Thus, in the end, multipliers are difficult and expensive to determine, and the result will still have quite a bit of uncertainty, anyway. On the practical side, it has been argued that in a near-full-employment economy like Australia’s, government spending diverts resources from other sectors and generates costs (inflation and interest rate pressures), not benefits. On the other hand, multipliers can be used to justify public investments to vested interests in areas such as arts, environmental improvements, sports and culture (because outcomes are often non-quantifiable). (C) Red Hill Capital Corp., Delaware, USA 2008 49 Supply-side Fiscal Policy (C) Red Hill Capital Corp., Delaware, USA 2008 50 Intro The monetary and fiscal policy that we have looked at are meant to affect the demand side of the economy, AD. Supply-side economics has its roots in classical economics. Supply-side fiscal policy, therefore, emphasizes policy that will promote AS in order to grow output and fight unemployment and inflation. Indeed, the persistent stagflation of the 1970’s was blamed on governments’ failures to follow supplyside economic policies, which were finally used in the early 1980’s. (C) Red Hill Capital Corp., Delaware, USA 2008 51 Example comparison Suppose that the economy is in equilibrium, E1 (see, slide, below), at $480 billion real GDP and a price index level of 150. The economy is experiencing high employment but the policy goal is to achieve full employment at real GDP = $500 billion. One alternative is Keynesian expansionary fiscal policy with increased G or decreased T to act through the multiplier to increase AD. However, it will also result in increase price level. (C) Red Hill Capital Corp., Delaware, USA 2008 52 Example comparison Supply-side economists, instead, prescribe that fiscal policy should be to encourage firms to want to produce more output at every price level. Such policies could include increasing the efficiency with which resources are produced, technological advances, government subsidies or tax breaks, and reduction in regulatory burdens. Then, AS will move right, the intersection with AD will be at higher real GDP but with actually lower prices. We show the two situations in the next slide. (C) Red Hill Capital Corp., Delaware, USA 2008 53 Supply vs. demand-side, graphically Increase in G Or Decrease in T Increase In AD Real GDP vs. Price level Decrease in resource prices, T, or regs; Increase tech or subs. Increase In AS Real GDP vs. Price level AD2 AS1 E2 E1 E1 150 E2 AD1 AS2 $480 $500 (C) Red Hill Capital Corp., Delaware, USA 2008 $480 $500 54 Recent examples of supply-side applications In 1981 in the U.S., the Reagan administration initiated tax cuts in a supplyside remedy to encourage increased supply at all price levels. Tax cuts were also part of the Keynesian prescription, where in DI is increased and AD increase through the multiplier. Supply-siders argue that increased DI provides incentive to supply labor, save and invest. Then, a tax cut will increase the amount of labor supplied and AS will increase. (C) Red Hill Capital Corp., Delaware, USA 2008 55 Recent examples of supply-side applications Increase in the AT wage rate encourages more work hours and tends to increase, and a decrease in BT wages might also result with an increase in hours supplied. Also, in the Reagan supply-side package were tax breaks that subsidized investment in PP&E and R&D. Supply-siders would argue that it was these moves which ultimately led to the long U.S economic expansion of the 1990’s and that the technological advances resulting from increased R&D led to the increased labor productivity of the second half of the 1990’s. (C) Red Hill Capital Corp., Delaware, USA 2008 56 Recent examples of supply-side applications In Australia between the mid-1980’s to mid1990’s the policy can also be viewed as supply-side in character. That included reduction in tariffs, deregulation of the financial system, competition policy reforms along with labor market and tax reforms. The aim of those policies was to increase the efficiency of the production process to encourage higher quantities supplied at any price and therefore supply-side in nature. (C) Red Hill Capital Corp., Delaware, USA 2008 57 The motivation of supply-side theory Arthur Laffer was a supply-side economist who was the proponent of the tax cuts of the 1980’s. The logic is explained by the so-called Laffer curve, which is the relationship between federal tax revenues versus the tax rate. The idea behind the Laffer curve is that the income tax rate affects the incentive for people to work, save and invest. Thus, as the tax rate increases, people are discouraged, and the result is a decrease in both national income and total tax revenues. (C) Red Hill Capital Corp., Delaware, USA 2008 58 The motivation of supply-side theory Supply-siders argue, but not without controversy, that the Laffer curve is upsidedown parabolic, much like the marginal product and profit curves, so there is a maximum point of tax revenues at a specific tax rate. The argument in the early 1980’s was that tax rates were above the maximal point, so that tax revenues were actually less than they would be, if rates were lowered. We show a theoretical Laffer curve in the next slide. (C) Red Hill Capital Corp., Delaware, USA 2008 59 Theoretical Laffer Curve Tax Revenues Rmax Tmax Tax Rate (%) (C) Red Hill Capital Corp., Delaware, USA 2008 60 The Federal Budget (C) Red Hill Capital Corp., Delaware, USA 2008 61 What is it? The federal budget is the principal fiscal policy statement of the federal government each year. In the announced budget for an upcoming fiscal year, revenues, expenses and financing are detailed for government operation, along with the underlying estimates of macroeconomic variables, like GDP growth, employment, wage growth, inflation, current account balance, etc. (C) Red Hill Capital Corp., Delaware, USA 2008 62 What is it? The budget outcome is of interest because it shows the size of government spending as a percentage of GDP to reveal the importance of government spending to the economy. Of particular interest to analysts is the budget balance, surplus or deficit. The size of the deficit/surplus is taken to indicate the government’s fiscal stance, i.e., the extent to which the government might be trying to expand or retard economic activity. (C) Red Hill Capital Corp., Delaware, USA 2008 63 What is it? A larger deficit will usually indicate expansionary policy that might lead to higher inflation and interest rates. A larger surplus will signal a damping of economic activity with lower inflation and interest rates. In Australia (see exhibit 17.6), the government ran deficits for most of the period from the mid-1970’s to the late 1980’s. Since that period, the government has mostly run at surplus. (C) Red Hill Capital Corp., Delaware, USA 2008 64 The counter cyclical role of fiscal policy The Keynesian view of fiscal policy calls for discretionary fiscal policy activism, i.e., the manipulation of AD to stabilize the business cycle. Such countercyclical policy implementation essentially calls for running deficits in recessions and offsetting surpluses during expansions. (C) Red Hill Capital Corp., Delaware, USA 2008 65 The counter cyclical role of fiscal policy Critics of that approach say that governments tend to inappropriately stimulate economies for more years than are really necessary. In fact, in the late 1990’s, the incoming government in Australia announced that there would be greater fiscal discipline to ensure that the federal budget will remain in balance on average in future years. (C) Red Hill Capital Corp., Delaware, USA 2008 66 Cautionary notes Although the size of the deficit/surplus is generally interpreted as a summary measurement of the extent to which policy is expansionary, there are some important caveats. First, we must look below the surface of the actual summary bottom line deficit/surplus figure. There are many ways that a government can provide economic stimulus or braking. (C) Red Hill Capital Corp., Delaware, USA 2008 67 Cautionary notes For example, the government might have reduced taxes, lowering revenues, but it is important to observe which taxes have been cut. There are excise, personal, payroll, corporate, and import taxes, to name a few. Each type will have focuses on different sectors of the economy and different ultimate macroeconomic affects. (C) Red Hill Capital Corp., Delaware, USA 2008 68 Cautionary notes Consider personal income taxes. A tax cut might be in the high end of earnings or targeted at the lower income earners. Thus, it will affect, not only different groups of people but also consumption and savings results. Reduced taxation on investment will affect I rather than C in AD. (C) Red Hill Capital Corp., Delaware, USA 2008 69 Cautionary notes On the expenditure side, increased spending could focus on actual government consumption on things varying from building roads or building a new government house. It might be, instead, increased transfer payments to one or a number of different socioeconomic groups, which will also have different consumption results. (C) Red Hill Capital Corp., Delaware, USA 2008 70 Cautionary notes Another sub-surface examination must focus on the domestic budget deficit, domestic revenue minus domestic spending, out of the overall deficit. Although the bulk of revenues derive from domestic sources, expenses can be spending on domestic or foreign goods, a good example being defense spending. Thus, even though government spending and deficit might have increased, it is important to note how much of that money is being spent domestically and on whom and how much on imports. (C) Red Hill Capital Corp., Delaware, USA 2008 71 Cautionary notes As a result, increased spending might not mean increased domestic spending. As we discussed, there are passive affects on the budget balance from the economic cycle, itself. For example, when the economy is in recession, tax collections will be less and unemployment benefit payments will increase. (C) Red Hill Capital Corp., Delaware, USA 2008 72 Cautionary notes A better measure, therefore, of what the government is specifically doing, trying to aid expansion or retard it, is called the cyclically adjusted budget deficit. That measure will give a more clear indication of the government’s fiscal policy stance. (C) Red Hill Capital Corp., Delaware, USA 2008 73 Other roles of fiscal policy 1. In addition to the cyclical stabilization, fiscal policy is used to achieve medium to longer tem economic and social goals. The enactment of the GST (goods and services tax) is a recent example in Australia. The objectives of that were: To remove distortions of tax-induced consumption patterns by applying tax to more items, thus, spreading the burden of taxation more widely and evenly across the economy. (C) Red Hill Capital Corp., Delaware, USA 2008 74 Other roles of fiscal policy 2. 3. 4. 1. Reduce the reliance of the government on income tax revenues. Reduce the ability of people to avoid taxes. Encourage increased savings by taxing income when it is spent rather when it is earned. Another example is the micro incentives that the government has initiated to deal with unemployment. These include: The creation of a publicly-funded job network (information increase). (C) Red Hill Capital Corp., Delaware, USA 2008 75 Other roles of fiscal policy 2. 3. 4. New rules linking unemployment benefits to actively trying to get a job, retraining or doing part-time volunteer projects. Limited employer subsidies to encourage employers to employ long term. The removal of disincentives associated with the interaction of the welfare and taxation system, which have made it sometimes better for someone to remain unemployed rather than get a job. (C) Red Hill Capital Corp., Delaware, USA 2008 76 Budget outcome and government debt When a government runs a deficit it must be financed with debt, and the government issues government debt securities, through the RBA, like T-bond and T-notes (T for treasury). If some of those securities are bought by the RBA. Then part of the deficit is monetized, and the financing is referred to as money financing of the deficit. The government helps pay for its expenditures with newly created money. (C) Red Hill Capital Corp., Delaware, USA 2008 77 Budget outcome and government debt The rest of the financing is pure debt financing. A useful figure is, therefore, the national debt, the total outstanding federal government debt, the cumulated unpaid debt to finance deficits. In Australia, it has gone from just under 40% of GDP, in 1960, to just over 5% by the end of the 1990’s, and is all but disappeared, today. (C) Red Hill Capital Corp., Delaware, USA 2008 78 Budget outcome and government debt In turn, government borrowing creates the concept of burden of debt of the Australian people since it is their whole burden. Currently, it is about AUD3,000/person. Part of the debt is held by foreigners and part domestic. Thus, the domestic part is debt that the people owe to themselves since they own it and get paid interest from it. (C) Red Hill Capital Corp., Delaware, USA 2008 79 Budget outcome and government debt There is only this redistribution effect of all paying the ones who purchased the debt. In addition, we must consider the other side of the government’s balance sheet, assets. Some of the government spending and consequent debt is for things, like infrastructure: highways and other public works capital assets. Then, debt for spending that does not add to the public capital stock could become a burden on future generations for current spending. (C) Red Hill Capital Corp., Delaware, USA 2008 80 Crowding out of the debt markets Critics of Keynesian fiscal policy point out the debt created to help GDP also hurts it since the government debt displaces private debt that could have been. As the government enters the debt market it becomes part of demand for savings, and the competition further adds pressure to interest rates. (C) Red Hill Capital Corp., Delaware, USA 2008 81 Crowding out of the debt markets Thus, private-sector borrowers who might have borrowed to consume or invest are crowded out of the market by the government’s presence. As a result, borrowing to create AD may also contribute to a reduction in AD. Proponents of Keynes counter that if the deficit spending adds to the public-sector capital stock, then, there is no crowding out. (C) Red Hill Capital Corp., Delaware, USA 2008 82 Crowding out of the debt markets Also, people might view that government spending as positive, in that the increased spending will act by multiplier to affect C an I. The real focus is on whether the government spending increases infrastructure or is simply wasted on current consumption by government. (C) Red Hill Capital Corp., Delaware, USA 2008 83 The external component of debt. External debt is not self-owed: the Australian nation owes repayment of principal and interest to foreigners. Thus, again, it depends on whether the debt financed public capital accumulation or current government consumption. If it is to finance current consumption it is not a good thing. (C) Red Hill Capital Corp., Delaware, USA 2008 84 How real is the budget deficit? Some economists argue that we should look at real, not nominal, increases in national debt. For example, if the national debt is $4 trillion, and inflation is 5% for a year, then, $200 billion (=5% x $4trillion) should be subtracted from the current budget deficit to adjust for the gain. Indeed, the federal government uses only one budget, instead of an operating budget and a capital budget, like businesses do, to match capital expenditures with long-term benefits, like in depreciation, in business. (C) Red Hill Capital Corp., Delaware, USA 2008 85 How real is the budget deficit? Such accounting would also make budget deficits shrink. Another argument about the federal budget deficit is that, instead, we should focus on the sum total of state and local budget surpluses and deficits, added to the federal. It is often the case that state and local governments run budget surpluses. Those would contribute funds into the financial markets, offsetting the crowding out by federal government borrowing. (C) Red Hill Capital Corp., Delaware, USA 2008 86 Exam-Caliber Questions Question 1. a) Assume that the economy is in the expansionary phase of the business cycle. There is a large inflationary gap and a budget deficit. Analyze how fiscal policy can be used to stabilize the economy. b) Discuss the key strengths and limitations of using fiscal policy to stabilize the economy. (C) Red Hill Capital Corp., Delaware, USA 2008 87 Exam-Caliber Questions 1. Advocates of supply-side fiscal policy recommend which of the following combinations of policy? a) Lower tax rates, spending cuts and increased government regulation b) Lower tax rates, lower resource prices and decreased government regulation c) Lower tax rates, spending increases and decreased government regulation d) Lower tax rates, spending increases and increased government regulation e) Higher tax rates, spending cuts and decreased government regulation (C) Red Hill Capital Corp., Delaware, USA 2008 88 Ask Yourself 1. 2. 3. Can you explain why the multiplier for transfer payments, like unemployment benefits, is the same as for changes in taxes? Can you explain why the balanced budget multiplier is equal to one? Can you explain why supply-side fiscal policy might result in expansion of output without inflation whereas standard fiscal policy based on spending might cause inflation, both in words and graphically? (C) Red Hill Capital Corp., Delaware, USA 2008 89 Ask Yourself 4. 5. 6. Do you know the difference between debt financing and money financing? Can you argue that fiscal policy is more effective than monetary policy for affecting output, or vice versa? What kind of government spending, financed by deficits, may not result in a burden of debt? (C) Red Hill Capital Corp., Delaware, USA 2008 90 Homework 1. 2. Chapter 17 All problems All multiple choice. (C) Red Hill Capital Corp., Delaware, USA 2008 91 Ending Next monday, we will have a final lecture Next week we will have practice exams in tutorials. (C) Red Hill Capital Corp., Delaware, USA 2008 92 END (C) Red Hill Capital Corp., Delaware, USA 2008 93
