Fiscal Policy

Fiscal policy is the manipulation of government spending, taxation and borrowing, affecting aggregate demand.
Fiscal policy can influence the current balance and imports through its effects on AD
1. A rise in government spending will increase AD and shift the AD curve to the right (assuming constant price level).
2. A cut in income tax and National Insurance Contributions will lead to increased disposable income for households. This will lead to increased consumption, and hence a rise in AD and a shift to the right of the AD curve (assuming constant price level).
3. The economy overheats if AD is increased when the economy is already at its full productive potential, resulting in increasing inflation with little or no increase in output
  1. 2006/7 due to labour spending
4. The effect on AD is increased by the multiplier effect. The multiplier effect will be larger the smaller the leakages from the circular flow of income. In a modern economy, leakages from savings, taxation and imports are a high proportion of national income so the multiplier is likely to be small. However, Keynesian economists argue it can still have a significant impact on the output of an economy if there is spare capacity (i.e. below full employment)
  1. Multiplier can be positive or negative (when funds are withdrawn).
5. Macroeconomic variables
  1. Full employment Little or no inflation High growth rate External balance (current account) equilibrium
    1. Inflation
      1. An increase in government spending or a fall in taxes which leads to a higher budget deficit or lower budget surplus tends to be inflationary, because expansionary policy leads to an increase in AD, which leads to demand pull inflation because as the AD curve shifts out, the price level rises.
        The size of the change in government spending or taxation. The larger the change, the larger the impact on inflation.
        The elasticity of the AS curve. In the short run it is relatively elastic so a shift out will have a small impact on the price level. However, in the long run the elasticity varies. Classical economists argue that the long run AS curve is vertical so an increase in AD has a large impact on prices. Keynesian economists argue that the LRAS curve is L shaped. Where the AS curve is horizontal, there is a lot of spare capacity and unemployment so any increase in AD will have no impact on prices. However, when the AS curve begins to steepen, an increase in AD leads to inflation. The nearer to full employment that the economy operates, the greater the rise in inflation will be from a given rise in government spending or fall in taxation.
    2. Unemployment
      1. A higher budget deficit or lower budget surplus tends to reduce unemployment (in the short term) because expansionary fiscal policy (higher government spending) leads to an increase in AD, which leads to a higher equilibrium of national output, and the higher the level of national output, the lower the level of unemployment.
        The size of the change in government spending or taxation. The larger the change, the larger the impact on AD and the labour market.
        If LRAS is vertical an increase in AD leads to higher inflation and has no effect on GDP or unemployment.
        In the classical model, demand side fiscal policy cannot be used to alter unemployment levels in the long term.
        This is also true for the Keynesian model if the economy is at full capacity. However, at output levels below this, expansionary fiscal policy will lead to a higher output and lower unemployment. If the AS curve is horizontal, expansionary fiscal policy can decrease unemployment without increasing inflation.
    3. Economic Growth
      1. Expansionary fiscal policy is unlikely to affect the long term growth rate of an economy because economic growth is caused by supply side factors such as investment, education and technology. However, expansionary fiscal policy will increase GDP in the short run. An increase in AD (below full capacity) will lead to a higher output. Keynesian economists argue that expansionary fiscal policy is an appropriate policy to use if the economy is in recession below full employment, to shift the AD curve so that the new equilibrium is on the vertical part of the AS curve and the economy is back to operating on its PPF. However, fiscal policy which pushes the AD curve beyond the start of the vertical AS curve would lead to no extra output but would be inflationary, so the economy would be over-heating. Classical economists argue that fiscal policy cannot be used to change real output in the long term because the LRAS curve is vertical, so shifting AD out has no effect on output.
        shifting AD out has no effect on output.
        Multiplier can lead to increased investment, so LRAS may shift out
        The nature of government spending - e.g. on training schemes and education can cause LRAS to shift out
    4. Balance of Payments
      1. Expansionary fiscal policy leads to an increase in AD, so domestic consumers and producers will have more income, and so will import more goods. Therefore, the current account position will deteriorate. Tighter fiscal policy will reduce domestic demand and imports will fall. The current account position should then improve. There may be other factors influencing exports and imports. If domestic demand falls because of tighter fiscal policy, then domestic firms may increase their efforts to find markets overseas. A fall in AD due to tighter fiscal policy should moderate the rate of inflation. British goods will become more competitive in the foreign markets, increasing exports and reducing imports, which improves the current account position.
        The net export effect reduces the competitiveness of fiscal policy by offsetting its effects. Expansionary fiscal policy leads to higher interest rates, which cases the currency to appreciate and exports to decline. Contractionary fiscal policy causes a fall in interest rates, a depreciation of the currency and an increase in net trade
      2. Government borrowing and expansionary fiscal policy tends to push up the interest rate (monetary policy to combat the rising inflation due to AD shifting out), increasing the returns on bonds, attracting hot money. High demand for the currency will raise its value. The £ will strengthen, leading to an increase in the price of exports and a fall in the price of imports, resulting in a fall in net trade.
        Countries with high FPI (foreign portfolio investment) can experience heightened market volatility and currency turmoil during times of uncertainty
    5. The government is unlikely to be able to achieve improvements in one without sacrificing another
      1. Expanding the economy to bring it out of recession and reduce unemployment will lead to higher inflation
      2. Tightening fiscal policy to reduce inflation will lead to higher unemployment and lower GDP
      3. Contracting the domestic economy by tightening fiscal policy to improve the current account situation will lead to lower inflation but higher unemployment
6. Increased confidence - firms invest more and consumers spend more
7. Reduced taxes - greater incentive to work - more contributions to revenue and also higher incomes so increased spending. Also firms invest more due to lower corp tax
Keynes vs Classical
1. Classical economists argue that fiscal policy cannot affect the level of output in the long term, and therefore cannot influence unemployment but can raise inflation
  1. Classical economists believe that since the economy is at full capacity in the long run, if government spending increases or fiscal policy is loosened, inflation will increase when AD shifts out because the new equilibrium with the LRAS curve is at a higher price level. This would be due to a shortage of the factors of production. They would then implement monetary policy and increase interest rates to encourage saving and to reduce AD. Supply side factors can also be used to control this effect because if LRAS shifts out then there will not be inflation. Other factors that can shift our LRAS are if the multiplier causes increased investment or just the nature of government spending. If (like Blair) spending on education is increased then LRAS will shift out because it affects the supply and quality of labour.
  2. Conservatives
    1. Tend to tighten fiscal policy - reduction in the quantity and quality of services and benefits provided by the government
2. Keynesian economists argue that fiscal policy can affect both output and prices and therefore can be used to influence both inflation and unemployment
  1. Labour
  2. During recession if gov spending increases, this will increase confidence, and stimulate demand and consumption and investment and lead to a multiplier effect. This is expansionary fiscal policy. The initial injection creates jobs and the workers employed will spend more etc...The gov will have to run a large deficit but these can be repaid using the fiscal dividends. During booms, contractionary fiscal policy should be used to slow down growth. there is a danger of over heating with higher inflation and a higher current account deficit as the economy sucks in imports to meet domestic demand. the government will reduce spending and increase taxes, and the net withdrawal should put downward pressure on consumption and investment growth and this is supported by a negative multiplier effect.
    1. Fiscal policy cannot influence long term economic growth, but it can be used to help an economy out of a recession or reduce demand pressures in a boom
    2. The budget deficit as a tool of demand management: Keynesian economists would support the use of changing the level of borrowing as a way of fine-tuning or managing the level of aggregate demand. An increase in borrowing can be a stimulus to demand when other sectors of the economy are suffering from weak spending. The fiscal stimulus given to the British economy during 2002-2005 has been important in stabilizing demand and output at a time of global uncertainty. The argument is that the government can and should use fiscal policy to keep real national output closer to potential GDP so that we avoid a large negative output gap. Maintaining a high level of demand helps to sustain growth and keep unemployment low.
Evaluating Fiscal Policy
1. Crowding out - higher gov spending may lead to lower investment because there will be fewer opportunities for private entrepreneurs to suppy goods and services. e.g. the bond market and interest rates. A budget deficit may be funded by issuing bonds but this absorbs spending by households and firms thus reducing spending on non-bond goods and services. Hence there is no overall increase in AD. Persuading households and firms to buy bonds may also require an increase in the interest rat offered, placing upwards pressure on the interest rates in the economy resulting in monetary contraction. This negative effect will be weaker if the bonds are sold to foreigners as well as to UK households and firms.
  1. Some economists argue that expansionary fiscal policy (higher government spending) will not increase AD, because the higher government spending will cause a decrease in the size of the private sector. This is because government will have to increase taxes or sell bonds and borrow money to finance the spending. These reduce private consumption or investment because after buying bonds/paying higher taxes, the private sector have lower funds for private investment. AD will only grow slowly, if at all.
    1. Classical economists argue that the govt is more inefficient in spending money than the private sector therefore there will be a decline in economic welfare
      1. Increased government borrowing can also put upward pressure on interest rates. To borrow more money the interest rate on bonds may have to rise, causing slower growth in the rest of the economy
    2. In a deep recession (liquidity trap), higher government spending will not cause crowding out because the private sector saving has increased substantially
    3. Monetary authorities could counteract crowding out by increasing the money supply to accommodate fiscal policy
2. It takes time to identify a problem, implement the policy and see the impacts - time lags.time lags are an example of gov failure because the cannot respond rapidly to changes in the economy. Time lags involved are often shorter than those for monetary policy - usually 1 year
  1. A situation could be that the state of the macroeconomy suddenly changes significantly and the policy the opposite to that required. e.g. a previous boom has led to fiscal contraction which by the time it takes effect pushes the economy into deeper recession
3. Classical economists - any attempts to increase output and reduce unemployment using AD policy will only create inflation
4. Keynesian economists - The success of demand side policies depends on the existing level of unemployment (spare capacity) in the economy - the nearer we are to full employment, the harder it is to create jobs, and the higher the impact on price level. As AD shifts out towards the vertical section of the AS curve, the effects on employment and output decrease and inflation increasesmore withevery shift.
5. Using fiscal policy as a means of improving supply-side performance - for example changes in corporation tax, tax and welfare reforms to improve work incentives, to meet environmental targets - carbon taxes to reduce C02
6. Using it as an inequality correction tool
7. The extent to which fiscal policy is now an effective tool of macroeconomic demand management - especially at a time when the conventional use of monetary policy seems to have lost traction as a result of the credit crunch
8. Increasing Taxes to reduce AD may cause disincentives to work, if this occurs there will be a fall in productivity and AS could fall. However higher taxes do not necessarily reduce incentives to work if the income effect dominates. Also, in a time of AD shifting in (downturn) people will be happy to just keep their jobs so productivity may remain the same
9. The effectiveness of fiscal policy will also depend upon the other components of AD, for example if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending.
10. Reduced govt spending could adversely effect public services such as public transport and education causing market failure and social inefficiency therefore lowering living standards.
11. The government may have poor information about the state of the economy and struggle to have the best information about what the economy needs. Fiscal policy will suffer if the govt believes there is going to be a recession, increases AD, but this forecast was wrong and the economy grows too fast, the govt action would cause inflation.
12. Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget deficit which has many adverse effects. Higher budget deficit will require higher taxes in the future and may cause crowding out.
13. Any change in injections may be increased by the multiplier effect, therefore the size of the multiplier will be significant.
  1. Bigger multiplier = bigger impact on AD
14. Government spending is inefficient. Free market economists argue that higher government spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to reduce spending in the future because interest groups put political pressure on maintaining stimulus spending as permanent.
15. Under certain conditions, expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments.
16. It depends on other factors in the economy. For example, if the government pursue expansionary fiscal policy, but interest rates rise and the global economy is in a recession, it may be insufficient to boost demand.
17. Liquidity trap
  1. Monetarists argue that government borrowing merely shifts resources from private sector to public sector and doesn’t increase overall economic activity. Increases in government borrowing will push up interest rates and crowd out private sector investment. E.g. Japan in the 1990s where a liquidity trap was not solved by government borrowing and a ballooning public sector debt.
  2. Keynesians argue that a liquidity trap makes fiscal policy very important for getting an economy out of a recession. Since interest rates are zero but aggregate demand is still falling, governments need to intervene to ‘crowd in’ resources left idle. The rise in private sector saving needs to be offset by a rise in public borrowing. The government can inject spending into the economy by increasing government spending. This increases aggregate demand and leads to higher economic growth without crowding out because the private sector saving has increased substantially.
  3. Liquidity trap: When monetary policy becomes ineffective because, despite zero / very low interest rates, people want to hold cash rather than spend or buy liquid assets. E.g. cut in interest rates in early 2009, failed to revive economy.
  4. Keynesians respond by saying that although government borrowing might cause crowding out in normal circumstances, in a liquidity trap, the rise in savings means that government borrowing won’t crowd out the private sector because the private sector resources are not being invested, just saved. Resources are effectively idle. By stimulating economic activity the government can encourage the private sector to start investing and spending again (hence the idea of ‘crowding in’)
  5. Causes
    1. Expectations of deflation
    2. Preference for saving
      1. Consumers, firms and banks are pessimistic about the future, so they look to increase their precautionary savings and it is difficult to get them to spend. This rise in the savings ratio means spending falls.
    3. Banks don't want to lend
      1. In recessions banks are much more reluctant to lend. Cutting the base rate to 0% may not translate into lower commercial bank lending rates as banks just don't want to lend.
      2. They are seeking to improve their balance sheets. They are reluctant to lend so firms and consumers cannot take advantage of low interest rates.
    4. Unwillingness to hold bonds
      1. If interest rates are zero, investors will expect interest rates to rise sometime. If interest rates rise, the price of bonds falls. Therefore, investors would rather keep cash savings than hold bonds.
18. If there is concern over the state of government finances, the government may not be able to borrow to finance fiscal policy. Countries in the Eurozone experienced this problem in the 2008-13 recession.
19. The success of fiscal policy depends on the state of the economy. Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand.
20. If expansionary fiscal policy occurs during periods of deflation it is likely to fail to boost overall aggregate demand. It is only when people expect a period of moderate inflation that real interest rates fall and the fiscal policy will be effective in boosting spending.
21. Responsiveness of changes in taxes to changes in GDP
22. What kind of fiscal policy - spending on what? Cuts in taxes for whom?
  1. estimating the magnitude of the effects is hard
23. Fiscal policy is ineffective when investment is very sensitive to interest rates and when consumers attempt to offset the actions of the government (e.g. saving a tax cut, or increasing their saving when higher government spending leads to expectations of higher taxes in the future)
Government Budget
1. Borrowing
  1. When a government runs a budget deficit, it has to borrow money. Borrowing of the public sector over a period of time is called the public sector net cash requirement (PSNCR).
    1. An increase in government spending or a fall in taxes which increases the budget deficit or reduces the budget surplus is called Expansionary Fiscal Policy. Fiscal policy is said to loosen as a result of these.
      1. Expansionary fiscal policy - fiscal policy used to increase AD
      2. 2010 Coalition Government - lower taxes but reduced provision of services
    2. There is a deficit when revenue is lower than spending
      1. Deficit is around 6% of GDP but peaked at 11% in 2010
      2. Deficit is amount borrowed yearly
        Sustained deficit means the economy is not self-sustaining
      3. The deficit can be funded by borrowing. Governments do this by issuing bonds which are a form of IOU. The funds rasied from selling these bonds can be used for capital spending projects or to fund current expenditure (unsustainable). The total value of outstanding bonds is the national debt.
        The accumulation of the total money owed is the national debt. It is about 89% of GDP (due to rescuing the banks in 2008). 40% of GDP is the sustainable level of national debt.
        $1.3 trillion ($46bn due to interest)
        A budget deficit can have positive macroeconomic effects in the long run if it is used to finance extra capital spending that leads to an increase in the stock of national assets, improving the supply-side capacity of the economy.
      4. However, if the budget deficit rises to a higher level, the government may have to offer higher interest rates to attract buyers.
        In the long run, higher government borrowing today may mean that taxes will have to rise in the future and this would put a squeeze on spending by private sector businesses and millions of households.
        This means that the Gov has to spend more each year in debt-interest payments.
        There is an opportunity cost because interest payments might be used in more productive ways, for example an increase in spending on health services. It also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy
    3. Should not occur at full employment
  2. When a government runs a budget surplus, there is negative PSNCR as there is no need to borrow money. This allows the government to pay off part of its national debt.
    1. Decreased government spending or increased taxes, which lead to a higher budget surplus or lower deficit is tightening of fiscal policy.
      1. Austerity measures
        Austerity measures are generally unpopular because they tend to lower the quantity and quality of services and benefits provided by the government.
        Stabilised prices when inflation is getting out of control
      2. Contractionary/Deflationary policy
      3. Consumers spend less due to higher taxes (lowers disposable income) and low confidence. Also increase disincentive to work so productivity and unemployment increases. The government spends less. Firms invest less due to higher taxes and reduced confidence
        AD shifts inwards
    2. Using the surplus to decrease debt may cause interest rates to fall, stimulating spending, which could be inflationary. It is better for the funds to just sit
2. Tax
  1. Corporation Tax
    1. Lowering the corporation tax leads to increased investment and FDI. For example, Ireland's rate is 12% and this attracted companies like Amazon and Google. It also encourages investment and risk taking
      1. However too much confidence can be a bad thing since people start going for too risky/low return investments simply because they can, and money can be lost
  2. Income tax
    1. Progressive - as income rises, the tax rate rises
      1. Thresholds - 20% for those earning less than £30,000. 40% for earnings between £30,000 and £150,000 and 45% for earnings of above £150,000
        Guaranteed income £10,000
        Gov can control this guaranteed portion and therefore consumption?
        Reduce the tax free allowance but keep the tax rates low e.g. 10% OR raise the allowance (allowing people to keep more of their income) but increase taxes to say 30%
      2. Helps reduce inequality - if tax was regressive (flat rate) the poorest would be hit hardest
    2. High income tax deters people from working. Also the higher skilled and higher income works look abroad for better salaries post-tax under less punitive tax regimes - brain drain effect.
  3. Effects depend on responsiveness of changes in tax to changes in spending /investment etc - proportion of income etc...
3. Spending
  1. There are 2 types of government spending. Capital spending increases the productive capacity of the economy, shifting LRAS to the right. It includes investment in infrastructure and building more schools and hospitals. Current spending is the day-to-day running of the public sector and includes purchasing raw materials for school supplies/drugs, paying wages etc...When an economy is in recession, shifting out LRAS will have little effect because the economy is not a full employment, so capital spending should be done when the economy is booming, so that loosening fiscal policy in a recession does not cause inflation - there is room for AD to shift out before it becomes inflationary.
    1. Unrealistic for the budget to balance because there is additional capital spending. Therefore the rule should be that current spending must equal tax receipts over the economic cycle.
  2. The golden rule states that the budget should be balanced over an economic cycle. As the economy moves from a boom to a downturn or recession, government spending should increase and tax revenue fall. This is called fiscal drag and it has a stabilising effect on the economy. As unemployment rises in a downturn, the government budget moves into a deficit as the injection provided outweighs the withdrawal through taxes, creating a net injection and increasing AD. As growth outstrips trend growth, there is likely to be an increase in tax receipts and a fall in government spending as fewer households require benefits. This is called a fiscal dividend - the benefit to the budget position of strong short term growth. The net withdrawal slows the circular flow of income and may dampen the impact of growth. However by removing the peaks and troughs of the economic cycle, the impact on living standards is lower.
  3. Actual budget surplus/deficit may differ greatly from full employment estimates
    1. Full employment budget measures what the gov deficit/surplus would be with the current rates of gov spending and taxation, if the economy was at full employment
Government spending OR taxation
1. If there is concern over unmet social needs or infrastructure, higher government spending during recessions and higher taxes during inflationary times is better
2. If the government is too large or inefficient, lower taxes during recessions and lower government spending during inflationary periods is better

Next up

Fiscal Policy

Description

Resource summary

Media attachments

Similar

	Created by Kati Christova about 10 years ago