Download Eco120Int_Lecture7

ECO 120
Macroeconomics
Week 7
Fiscal Policy
Lecturer
Dr. Rod Duncan
Topics
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Definition of fiscal policy
How fiscal policy works
Limitations to fiscal policy
Crowding out
Government debt
Fiscal policy
• “Fiscal policy” is the government operation
of government spending (G) and taxes (T).
• Typically we consider the problem of how
the government can manipulate G and T
so as to control economic variables such
as output, inflation, interest rates, etc.
• Issues: how fiscal policy can “stabilize”
the economy? what about government
borrowing and public debt?
Definitions
• Budget deficit: the budget deficit is the
extent of overspending by the government
Budget deficit = G – T
• Expansionary fiscal policy: increasing
the budget deficit (G↑ or T↓) usually in a
recession.
• Contractionary fiscal policy: decreasing
the budget deficit (G↓ or T ↑) usually in an
economic boom.
Budget deficits and surpluses
• If the government spends more than it brings in
in taxes, what happens? (G > T)
• The money has to come from somewhere. For
developed countries, this means borrowing
(issuing government debt or “public debt”) from
domestic residents or foreigners.
• If the government is spending less than it brings
in in taxes, the government can reduce public
debt. The Australian government has followed
this policy in the last 10 years.
Types of fiscal policy
• We differentiate two types of fiscal policy:
– Discretionary fiscal policy: This is fiscal policy that
comes about from planned changes in G and T that
the government brings in in response to the economic
situation.
– Non-discretionary fiscal policy: This is fiscal policy
that comes about from the design of spending and
taxes. There is no government official actively
determining these changes.
Non-discretionary fiscal policy
• Certain parts of our spending and taxes
automatically increase demand in a recession
(when AD < potential GDP) and decrease
demand in a boom (when AD > potential GDP).
– Welfare spending and unemployment benefits are
part of G and increase in a recession and decrease in
a boom.
– Income and company taxes are part of T and depend
on GDP, they increase during a boom and decrease
during a recession.
• These act as “automatic stabilizers” on the
economy, reducing the variability of the
economy.
Stabilizing a recession
• In a recession,
current output is
below the natural or
potential rate.
• We need policies to
shift the AD curve
right:
P
AS
AD
Y0
Yn
Y
– Increasing government
spending
– Cutting taxes to
increase disposable Y.
Example
• Fiscal policy to stabilize a recession
– Increase G
– Decrease T
Stabilizing a boom
• In a boom, current
output is above the
natural or potential
rate.
• We need policies to
shift the AD curve left:
P
AS
AD
Yn
Y0
Y
– Decreasing
government spending
– Raising taxes to
decrease disposable
Y.
Example
• Fiscal policy to stabilize a boom
– Decrease G
– Increase T
Cyclically-adjusted budget deficits
• The automatic stabilizers raise the budget deficit
in a recession and lower the budget deficit in a
boom.
• This fact means that we can not just look at the
budget deficit to determine whether the
government is “overspending”, we also have to
take into account where we are in the business
cycle.
• Adjusting the budget deficit for the point we are
in the business cycle is called “cyclically
adjusting”. We would expect even a “sensible”
government to be in a deficit in a recession.
Discretionary fiscal policy
• Discretionary fiscal policy is the
manipulation of G and T by government
officials typically to reduce the severity of
shocks to the economy.
• It sounds like a good idea, but how does it
work in reality?
• There are many problems and limitations
to the use of fiscal policy to reduce
recessions and booms.
Stabilizing through fiscal policy
• We would want to achieve the same effects that
the automatic stabilizers achieved: raise C and
G in a recession and lower C and G in a boom.
• Recession: lower taxes to raise disposable Y
and raise C, and raise G.
• Boom: raise taxes to lower disposable Y and
lower C, and lower G.
• In recession, government should go into budget
deficits. In booms, governments should run
budget surpluses.
Problems with discretion
• Scenario: Imagine a train driver that has
only one control- an accelerator/brake that
he or she can push or pull on to control the
train. This is exactly the same situation as
the government faces with fiscal policy.
• Now what limitations can the train driver
face?
Train driver scenario
Now
Output
Time
Problems with discretion
• Limitations:
– Correctness of data: Is the train driver seeing the
tracks correctly? Or Does the government get the
right data about where the economy is?
– Timing of data: Is the train driver seeing the tracks
with enough time to react? Or Does the government
get the statistics quickly enough to do anything?
– Decision lags: Can the train driver make a decision
about the correct action before the train reaches the
problem spot? Or does the government have time to
design the correct fiscal policy?
Problems with discretion
– Administration lags: If the driver pulls on the
control, how long will it take for the brakes to start to
work? Or New spending and taxes have to be
passed through parliament, which takes time, even
after a decision is made.
– Operational lags: If the brakes start to work, how
long before the train slows down? Or New
government spending and taxes take time to affect
the economy.
• So even the best-designed fiscal policies can go
wrong if they are in response to the wrong data
or if they take too long to affect the economy.
Political considerations
• There are further concerns we might have about
the operation of fiscal policy.
– Politicians have to remain popular. No one likes
taxes, and everyone likes new spending on
themselves. Will a politician make an unpopular
decision that may result in them losing the election if it
is the best decision for the economy.
– Electoral cycles: Governments have to be reelected every 3-4 years. So a politician would love to
engineer a boom right before his or her election.
Crowding out
• Another problem with fiscal policy is that an
increase in G may increase output but at the
expense of other components of aggregate
expenditure.
Y = C + I + G + NX
• Since the economy returns to potential GDP
over the long-run, an increase in G must come
at the expense of either C, I or NX or all 3.
• If an increase in G reduces investment spending
over the long-run, this could lead to lower future
growth in the economy.
Crowding out
• How can this happen?
– An increase in G shifts the AD curve to the right.
– This results in higher Y and higher P.
– The increased government borrowing in the market
for savings raises the interest rate.
– Higher interest rates lead to lower investment
spending so I drops, shifting AD left.
– Higher interest rates leads to an appreciation of the
A$ (as foreign investors put their money in Australia),
so NX drops, shifting AD left.
Example
• Increase in G
• Leads to a rise in interest rates
• Leads to lower I
Government debt
• One problem that economic commentators
always point to is the level of government debt“Our debt is too high.”
• How do we evaluate the level of government
debt? How do we know is it is “too high”.
• Government debt is like any other form of debt.
You evaluate the debt relative to the
income/wealth of the person incurring the debt.
• A $500,000 debt might be high to you and me,
but it might mean nothing to Kerry Packer.
Government debt
• So we need to evaluate government debt
relative to “government income”. But what
is the appropriate form of “government
income”, as the government doesn’t earn
or produce anything.
• Generally we use the income of the
country as the comparison, since the
government is free to tax or claim any part
of GDP.
Government debt
• So our criterion for “too much” is debt (B, since
typically government debt is issued in
government bonds) over GDP (Y):
B/Y
• Banks would make much the same calculation
when considering whether to issue someone a
home loan.
• In general debt is growing at the rate of interest
each year, r, while GDP is growing at the growth
rate of the economy, g.
Budget deficits and debt
Country
Australia
United States
European Union
Japan
OECD
Net Debt/GDP (%)
1985 1995 2000
15.0 23.5 9.7
41.9 58.9 43.0
34.1 53.8 48.0
69.7 24.8 58.6
41.4 48.8 44.1
2003
2.9
47.1
49.4
80.2
48.7
Primary Surplus/GDP (%)
2000 2003
2.4 1.7
4.1 -2.7
4.1 0.6
-6.1 -6.3
2.6 -1.5
.
Example question
Question
(a) We start at an initial LR equilibrium using
the AD-AS diagram.
(b) The Australian government increases G
to pay for added security at Australian
airports. Carefully indicate what impact
this might have on the Australian
economy.