Download Fiscal Policy

MACROECONOMIC POLICY IN THE
ASIA-PACIFIC
GECO6400
Fiscal Policy
FISCAL POLICY










The Public Sector
Fiscal Policy explained
Fiscal Policy and the Aggregate Expenditure Model
The Government Budget
Discretionary Fiscal Policy
Non-Discretionary Fiscal Policy
Budget Outcomes
Public debt.
Offer an evaluation of efficacy of fiscal policy.
We will compare budget outcomes in various countries.
FISCAL POLICY
All entities owned &/or controlled by Federal, state or
local governments
The Public Sector forms the 3rd macroeconomic sector in
the circular flow of income. The macroeconomy is no
longer a private macroeconomy but a public one.
The public sector is made up of all levels of government
(federal, state and local) and government institutions and
enterprises. They have a significant impact on
macroeconomic activity.
The federal government has the greatest impact due to its
size and scop of operations and influence, both financially
and legislatively.
FISCAL POLICY
The Public sector generally fulfills three
broad functions within an economy:
1. Resource Allocation
Dealing with externalities
Funding public goods (health, education,
defence etc.)
Regulating natural monopolies (railways,
water and electricity supply and pricing)
FISCAL POLICY
2. Income Redistribution
minimum standard of living (transfer payments
such as disability pensions, UB, etc).
Taking from the better-off citizens and giving it
to the less well-off through progressive income
tax, capital gain tax etc.
3. Output Stabilisation
Aim to facilitate growth and reduce the
amplitude of business cycle simultaneously.
Stabilisation goals (inflation & unemployment)
Government expenditure has multiplier effect
FISCAL POLICY
In this Lecture we are concerned with Stabilisation Policy only
and not with Allocation or Income distribution functions of the
Government
The Public Sector and Fiscal Policy
Fiscal policy is the Public Sector’s management of its revenue
and expenditure.
It is the financial side of policy implementation.
The government has at its disposal the taxes it collects and
debt it raises to spend.
It then uses these to finance its expenditure programs.
FISCAL POLICY
The Federal Budget sets out the expected revenue
and expenditure flows within a period of time.
Reviews the past performance of the economy.
Forecasts the key macroeconomic variables.
Sets out the policy changes and their policy
implications
FISCAL POLICY
The budget outcome is calculated as:
Revenue - Expenditure
Tax revenue:
Lump sum taxes (e.g poll
proportional taxes (GST)
progressive
tax)
taxes (income taxes).
Federal Government Expenditure:
Current expenditure.
Capital expenditure.
Transfer payments (aged pensions, current transfers and
grants to the states).
FISCAL POLICY
Government expenditure is treated like Investment &
Export expenditure (injection into the economy).
AE=C+I+G
Taxation is treated like Saving and Imports (leakage
out of the economy).
Leakages=S+T
Injections=I+G
FISCAL POLICY
Tax Revenue (T)
T are partially induced since income taxes are function of Real
GDP (Y).
General Form: T=TA + tY
where: TA = lump sum taxes
t = marginal tax rate
Numerical Example: T = 200 + 0.4Y
Government Expenditure (G)
G is assumed autonomous since it is a function of Budgetary
Policy decisions.
General Form: G= GA
Numerical Example: G = 1000
FISCAL POLICY
Government Expenditure and Taxation can be
represented on the leakages-injections diagram
(similar to Investment and Savings)
G and T
T=200+0.4Y
G=$1,000
200
OUTPUT
FISCAL POLICY
Budget Outcomes
Balanced Budget: revenue equals expenditure.
G=T
Slightly Expansionary. Balanced Budget Multiplier (not neutral).
Budget surplus: revenue is greater that expenditure.
Government earns more than it spends. Government is saving.
G<T
Contractionary.
Budget deficit: outlays are greater than revenue. Government spends
more than it earns.
G>T
Expansionary.
FISCAL POLICY
Taxes are a leakage from the circular flow
Therefore this impacts on the size of the multiplier.
Expenditure multiplier is now 1/MPS+t.
Note, savings are also affected by tax.
FISCAL POLICY
G and T
G>T
Budget Deficit
T>G
Budget Surplus
T = 200 + 0.4Y
T=G
Balanced Budget
1000
200
0
-800
G = 1000
Real GDP (Y)
Budget Outcome
T-G
FISCAL POLICY
A budget surplus is contractionary in an incomegenerating sense because the government takes more
money out of the Circular Flow of Income than it puts
in.
A budget surplus causes economic activity,
employment and inflation to decline.
FISCAL POLICY
Financing a Budget Deficit
The excess of expenditure over revenue means that a the
government needs to source extra funding for its activities.
It can do this in 2 ways:
Debt Financing
By borrowing from the public (getting into debt).
Government borrowing is done by selling IOUs (bonds) to
the general public. The buyer of the bonds (the Reserve
Bank of Australia or the private sector) determines the
nature of the finance obtained.
FISCAL POLICY
Monetising the Deficit
Printing more money (via the mint).
When the bank buys bonds from the government, it uses
newly-created money to do so.
This newly-created money flows back into the banking
system in the form of an increase in the monetary base.
An increase in MS causes an increase in AD.
Higher AD leads to an increase in the price level.
FISCAL POLICY
Monetising the Deficit
Persistent money financing of a budget deficit
leads to continuous increases in AD and to
inflation.
This can be more expansionary than debt financing
because more money is created and can support
more macroeconomic activity.
FISCAL POLICY
Monetising the Deficit
BUT, the Reserve Bank must accommodate the
increased money in the economy by at least
maintaining the general level of interest rates; or
This can lead to a rise in inflation (demand-pull).
G increases, but there is no real change in GDP
because there is more money but no change in the
output of goods and services.
FISCAL POLICY
Discretionary Fiscal Policy
This is the government’s deliberate regulation of its budget
to attempt to smooth out business fluctuations (to ensure
maximum employment and low inflation).
The government takes advantage of the impact that the
budget outcome has on economic activity and uses this to
achieve its policy aims.
Policy aims: high economic growth (GDP), low prices
(inflation), low unemployment.
Eliminate or reduce Inflationary or deflationary gaps
FISCAL POLICY
Deflationary gap: when potential GDP is greater
than actual GDP. The government should pursue
an expansionary fiscal policy to eliminate the gap.
Inflationary gap: when potential GDP is less than
actual GDP. The government should dampen the
economy through contractionary fiscal policy.
FISCAL POLICY
Types of Budget Outcomes
Actual: the basic outcome of the budget.
Structural: the budget outcome that would occur at full
employment or potential output. The structural budget
outcome indicates the type of discretionary fiscal
objective being sought by the government.
Cyclical: the actual budget outcome minus the structural
budget outcome. This is influenced by economic
activity.
FISCAL POLICY
The actual budget outcome can be expressed as:
BA=BC+BS
The structural budget is achieved at potential GDP. It is
calculated as the Actual budget outcome less the Cyclical
budget outcome:
BS=BA-BC
The cyclical budget outcome is equal to the actual budget
outcome less the structural budget outcome:
BC=BA-BS
FISCAL POLICY
Take our example:
T=200+0.4Y and G=2000
Now if actual GDP=3000
Actual Budget outcome is:
T-G =200+0.4(3000)-2000
=1400-2000= -600 ~ deficit
The stance of Fiscal Policy, judging from this
budget outcome, looks expansionary.
FISCAL POLICY
But let Potential GDP=5000
Structural budget outcome is:
T-G=200+0.4(5000)-2000
= 2200-2000 = +200 ~ surplus
The stance of Fiscal Policy, judging from this
budget outcome, looks contractionary.
FISCAL POLICY
The Cyclical budget outcome is:
T-G= actual – structural
= -600-200 = -800
Actual economic activity is lower that potential economic
activity, therefore the government’s taxation revenue falls
short of its budgeted level because this is based on
potential GDP.
Taking into account the state of the economy, the budget
needs to be more expansionary than it actually is.
That is, the government needs to increase its expenditure
(G) or reduce taxation (T) to get the economy to its full
potential.
FISCAL POLICY
AE
AE
YE=$3,000B
Actual Budget
Outcome
$600B Deficit
Equilibrium
GDP
45o
YP=$5,000B
Structural Budget
Outcome
$200B Surplus
3000
Real GDP
T&G
Budget Surplus G
Budget Deficit
Real GDP
LRAS
Cyclical Budget
Outcome
Actual-Structural
$800B Deficit
SAS
Price
AD
3000
T
5000
Real GDP
FISCAL POLICY
Automatic Stabilisers
Automatic stabilisers take some of the discretion out of
the budget outcome.
Automatic Stabilisers are institutional factors that are
set up by the government for various reasons (such as
equity or to provide a revenue base for budgetary
activity).
Once they are in place, they act counter-cyclically to
influence the outcome of the budget – they influence
government revenue and expenses.
Again, the emphasis is on income influencing
macroeconomic behaviour in a counter-cyclical way.
FISCAL POLICY
Built-in stabilisers that operate without requiring explicit
action by policy-makers
During recessions: Tend to increase government deficits (or
reduce surplus)
During inflationary periods: Tend to increase government
surpluses (or reduce deficits)
Examples of Automatic Stabilisers
Progressive Income Tax: as income increases, so does the
leakage of tax, reducing the impact of increased income on
spending.
Transfer payments: eg unemployment benefits. As income
declines, transfer payments increase, boosting AD and
keep the economy buoyant.
FISCAL POLICY
Automatic Fiscal Stabilisers
Budget Outcome
G and T
Budget Outcome
T-G
-800
Real GDP (Y)
As GDP increases the Budget moves from DEFICIT into SURPLUS.
FISCAL POLICY
Suppose the economy has found equilibrium at less
than full employment.
Any attempts to stimulate the economy will be muted
by the operation of the automatic stabilisers. This is
fiscal drag.
For example, increase Government spending by $300
with multiplier of 2. Change in Ye will be $600 but if
MPT = 0.4, then tax revenues will increase & dampen
Ye by $240.
Cure: Appropriate discretionary fiscal policy
FISCAL POLICY
The Actual budget outcome in any given year does
not necessarily indicate the government’s true fiscal
stance.
The presence of automatic stabilisers means that
the actual budget outcomes are sensitive to the
level of GDP.
To determine stance (expansion or contraction) of
budget look at the Structural budget outcome (what
is would be at potential GDP).
Billions of 1990 dollars
FISCAL POLICY
440
420
400
380
360
340
320
300
280
260
1980
Real
GDP
Potential
GDP
1985
1990
1995
2000
FISCAL POLICY
Crowding out
Crowding out occurs when the government
competes with the private sector for funds to
finance a budget deficit.
The competition for funds causes an increase in
demand for money and hence interest rates.
This slows down growth.
FISCAL POLICY
Fiscal Policy Transmission Mechanism and Crowding Out
Domestic Crowding Out
G  AE  Y  MD  IR  I  AE   Y
International Crowding Out
Overseas Sector: IR   D$A   ER  NX   AE   Y
FISCAL POLICY
Fiscal Policy Transmission Mechanism and Crowding Out
G  AE  Y  MD  IR  I  AE   Y
Aggregate Expenditure Model
AE
AE1
AE2
AE0
Money Market
IR
IR1
Investment Demand
MS
IR
IR0
ID
MD1
MD0
Y0 Y2 Y1 Real GDP
QM
I1
I0
I
FISCAL POLICY
Net Export Effect
The impact of interest rate-induced change in the
exchange rate, and thus net exports, following
changes in fiscal policy.
Freely-floating exchange rate system.
Expansionary Fiscal Policy
Results in higher interest rates. This increases the demand for the
$A leading to its appreciation and a decline in net exports, a
reduction in AE and a fall in GDP.
FISCAL POLICY
Net Export Effect
Contractionary fiscal policy
Results in lower interest rates. This reduces the demand
for the $A leading to its depreciation and an increase in
net exports, an increase in AE and an rise in GDP.
The Net Export Effect, with a freely-floating
exchange rate, reduces the overall impact of fiscal
policy on economic activity.
FISCAL POLICY
Crowding out and the Net Export Effect
Investment
Budget
Outcome
Interest
Rates
Aggregate
Demand
Exchange
Rate
Exports
FISCAL POLICY
Budget Deficits and Aggregate Demand
A Budget Deficit shifts AD to the right.
This increases output and prices
The full impact of FP will depend on price
elasticity of SRAS.
The more price elastic is AS, the greater will be the
impact on Y with smaller rise in price level.
FISCAL POLICY
AS
Price level
AD1 AD2
P3
P2
P1
Q1
Q2
Q2
Real GDP
FISCAL POLICY
Deficits & Aggregate Supply
Supply-siders argue for tax cuts – lower taxes
increases disposable income and encourages
saving and investment.
But they claim alter incentives to work.
Evidence on work incentive effects is VERY
weak.
FISCAL POLICY
Price level
AS1
AS2
AD1
P1
P2
P3
=
AD2
Q1 Q2 Q3
Real GDP
FISCAL POLICY
Lags
Problems of timing
 Recognition lags
 Administrative lags
 Implementation lags
Political problems
 Other economic goals: not just stability
 Expansionary bias
 A political business cycle
FISCAL POLICY
SUMMING UP
FP will be more effective in influencing economic
activity if:
Investment is not very responsive to interest rate changes.
International capital flows are not very responsive to
domestic interest rates.
SRAS is very price elastic.
Shorter are the policy lags.
Less political interference on policy stance.
FISCAL POLICY
Annually balanced budget
Pro-cyclical: intensifies recession or inflation
Cyclically balanced budget
Counter-cyclical
Not annually balanced
Problem: upswings and downswings may not be
of equal magnitude
FISCAL POLICY
Functional finance
Primary purpose is to balance the economy,
not the budget
The problems of continuing annual deficits
(or surpluses) may be small compared to the
alternative: recession and high
unemployment (inflation)
FISCAL POLICY
FISCAL POLICY
FISCAL POLICY
FISCAL POLICY
FISCAL POLICY
FISCAL POLICY
FISCAL POLICY
Public Debt
The total accumulation of the Federal Government’s total
deficits and surpluses over time
General govt sector net debt as share of GDP went below
zero in 2004-05.
Myths about public debt:
 Government is going bankrupt
Government can refinance existing debt – saw before
that debt really an instrument of monetary policy.
Can create more money
Shifting burdens, future generations will pay for it
FISCAL POLICY
FISCAL POLICY
Problems with Public Debt
Economic implications
 External debt may be a problem
Increased taxes may dampen incentives - but saw before
no necessary link between money, debt & taxes.
Income distribution
Government bonds are generally held by those wealthier
members of society
Composition important: capital versus consumer goods
FISCAL POLICY
Problems with Public Debt
Some argue there is a crowding-out effect and impact on the
stock of capital
Future generations inherit a smaller stock of capital goods
due to the crowding-out effect, which increases interest
rates and so reduces investment spending
But in an economy with unemployed resources a
government deficit, irrespective of how it is financed, has
potential to increase output of both consumption and capital
goods for an economy.
FISCAL POLICY
Public Debt: Positive Role
Saw before with Paradox of Thrift that if an economy’s
saving was not matched by investment (or other injection)
that economy would contract.
So borrowing & debt, transfer saving to spenders and
thereby play a positive function in maintaining a high level
of output and employment.
As well, government debt in the form of bonds offers
private sector a low risk interest bearing asset in which to
hold their wealth. Important to the depth & confidence of
financial markets.
FISCAL POLICY
Jackson & McIver, Chapter 8
McTaggart et al. Ch 25
Kniest, Lee & Burgess, Chapter 11.