12.2 Fiscal policy

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The government budget:

1. Sources of government revenue:

taxes of all types

-indirect and direct

-most important source of government revenue

from the sale of goods and services

-transportation

-electricity

-water

-revenues from these sales usually go towards covering the government's costs of providing them

from the sale of government-owned (state-owned enterprises or property)

-privatisation

-involves the transfer of ownership from the government to private owners

-when government sells enterprises it owns, it receives funds from the buyer equivalent to the price of the enterprise

2. Types of government expenditure:

-three types

1. Current expenditures:

-includes government spending on day-to-day items that are recurring and items that are used or consumed up as a good or service is provided

-wages, salaries for all government employees

-spending on day to day operation of government activities; school supplies, medical supplies

-provision of subsidies, interest payments on government loans

2. Capital expenditures:

-public investments

-production of physical capital; buildings, roads, airports, hospitals

3. Transfer payments:

-payments by the government to vulnerable groups for the purposes of income redistribution

-unemployment benefits, child allowances

3. The budget outcome:

government budget:

-a type of plan of country's tax revenues and expenditures over a period of time usually a year

balanced budget:

-if tax revenues are equal to the government expenditures over that period

-in practice the government's budget is rarely ever balanced

budget deficit:

-if expenditures are larger than tax revenue

-government finances for the excess of expenditures over revenues by borrowing

-similar to personal finance, where if you spend more than you earn, you likely borrow to pay for your extra spending over your income

-government debt is larger

budget surplus:

-if expenditures are smaller than tax revenues

-government debt is smaller

public debt/government debt:

-government's accumulation of deficits minus surpluses

Role of fiscal policy:

fiscal policy:

-manipulations by the government of its own expenditures and taxes to influence level of AD

-affects three out of the four components of AD

G

-level of government's own spending can be changed

C

-level of consumption spending can be influence if the government changes taxes on consumers (personal income tax) changing their level of disposable income which is the income of consumers after income taxes have been paid

I

-level of investment spending can also be influence if the government changes taxes on business profits

Expansionary fiscal policy:

-eliminate recessionary gap

-works to expand AD and the level of economic activity

consists of:

increasing government spending

-impacts directly on AD which increases

decreasing personal income taxes

-a rise in disposable income likely leading to an increase in consumption spending, AD shifts right

decreasing business taxes

-after-tax profits increase, likely to lead to higher investment spending, higher AD

combination of increasing spending and decreasing taxes

-can do so by borrowing to finance the excess of spending over tax revenues

-if initially it has a balance budget, increase in G while taxes remain constant or fall creates a budget deficit

-if already has a budget deficit at the outset, deficit will become larger

-if has budget surplus at the outset, surplus either become smaller or will shrink until it eventually turns into deficit

DIFFERENCES

-both new classical and Keynesian predict that increase in AD increases real GDP

-size of increase in real GDP will not be the same in both cases

-increase of real GDP will be smaller in monetarist/new classical model than Keynesian, due to upward sloping SRAS

-in monetarist/new classical, increase in AD results in rise in price level because of upward sloping SRAS

-in Keynesian, in crease in AD may result in no increase in price level if AD shift occurs entirely within the horizontal section of AS curve

-if AD shift reaches into the upward sloping part of Keynesian AS curve, only small increase in price level

Contractionary fiscal policy:

-close and inflationary gap

-words to contract AD and the level of economic activity

consists of:

decreasing government spending

-has direct influence on the AD curve shifting it left

increasing personal income taxes

-intended to affect AD in two-step process; as personal income taxes increases, after-tax income falls, consumption spending and AD falls shifting left

increasing business taxes

-intended to affect AD in two-step process; as taxes on profits increases, after-tax profits fall, business spend less on investment and AD fall shifting left

combination of decreasing spending and increasing taxes

-depending on initial conditions that prevail in the government's budget

-combination of policies would lead to creation of budget surplus of the shrinkage of a budget deficit or turning budget deficit into a surplus

DIFFERENCES

-effects of a fall in AD may be different depending on the model considered

-if AD falls in the downward sloping part of the AS curve in the Keynesian model, effects on the price level and real GDP are similar in the two models

-if the AD were to decrease into the horizontal part of the AS curve, the fall in real GDP will be larger and the drop int he price level smaller or none at all compared to with the monetarist/new classical model

Keynesian model with the ratchet effect:

-the price level moves up when there is an increase in AD, and then remains at the same level until there is a further increase in AD

-a feature of the Keynesian model is that the price level can easily increase with strong aggregate demand, but does not easily fall even as aggregate demand decreases. Therefore, the decrease in the price level shown does not make sense

-fiscal policy involves manipulations by the government of its own expenditures and taxes to influence the G, C or I components of AD

-expansionary fiscal policy can be used when there is a recessionary gap and aims to shift the AD curve tot he right leading to equilibrium at the full employment level of real GDP (potential GDP)

-contractionary fiscal policy can be used when there is an inflationary gap and aims to shift the AD curve to the left leading to equilibrium at the full employment level of real GDP (potential GDP)

Role of automatic stabilisers:

automatic stabilisers:

-factors that automatically without any action by government authorities work toward stabilising the economy by reducing the short-term fluctuations of the business cycle

-progressive tax system and unemployment benefits cannot by themselves stabilise the economy and eliminate inflationary and recessionary gaps. they can only help reduce the severity of economic fluctuations

-two important ones:

1. progressive income tax

upswing of the business cycle

-real GDP and incomes rises, government tax revenues automatically increase causing after tax (disposable) income to be lower than it would otherwise be

-lower disposable income acts to dampen AD

-counteracts the economic expansion or make it smaller than it would otherwise be

in a recession

-with real GDP and incomes falling, government tax revenues automatically decline

-putting upward pressure on AD reducing the severity of the recession

works better with progressive taxes

-works with both proportional and progressive income taxes

-the stabilising effects of income taxes are greater with progressive taxation

-with progressive taxation, the average tax rate increases as income/real GDP increases

-therefore in an upswing with higher real GDP, government tax revenues are relatively higher and disposable income relatively lower compared to what they would have been with proportional taxation

-in a recession, progressive taxes mean that as income/real GDP fall, disposable income is relatively higher than it would be with proportional taxation

-the higher the income bracket, the greater the income tax

2. unemployment benefits

in a recession

-as real GDP falls, unemployment increases, hence the need to unemployment benefits

-if there were no unemployment benefits, unemployed workers's spending would fall dramatically putting a strong downward pressure on consumption spending and AD

-having unemployment benefits means that as workers become unemployed, their consumption will be maintained, thus lessening the downward pressure on AD

in an expansion

-unemployment benefits are reduced as unemployment falls

-consumption increases less than it would in the absence of unemployment benefits

Indirect effects on potential output: SHIFTS LRAS RIGHTWARDS

-firms must plan what capital goods to invest in

-whether how and in what areas to pursue research and development and technological innovations

-investment is the key to the formation of new capital goods and R&D is the driving force of technological changes

-both of which are very important factors in increasing production possibilities and increasing the potential GDP which will shift the LRAS curve to the right monetarist/new classical context

-to be able to plan for the long-run, firms need economic stability, consisting of avoidance of sharp economic inflation and recession and unemployment

Direct effects on potential output:

1. they can allocate a portion of government spending to the development of physical capital goods

-infrastructure as well as R&D

-which improves technology

-improves the quality of capital goods and improves the productivity of labour

2. they can allocate a portion of government spending to the development of human capital

-training and education programmes

-increase the quality of the labour force

-improve the productivity of labour

strengths of fiscal policy:

-good at pulling an economy out of deep recession

-good ar dealing with rapid and escalating inflation

-ability to target sectors of the economy, can target different sectors with different levels of tax

-direct impact of government spending on AD

-ability to affect potential output

weaknesses of fiscal policy:

-subject to ability to manage fiscal deficit

-problems of time lags; there is a lag until

the problem (recessionary or inflationary gap) is recognised

the appropriate policy to deal with the problem is decided upon the government

the policy takes effect in the economy

-political constraints (application of taxation and merit goods)

-crowding out effect

-inability to deal with supply-side causes of instability

-expectations->in a recession, tax cuts may not be very effective in increasing AD

-inability to 'fine tune' the economy

crowding out effect:

-in order to spend sometimes, the government has to borrow

-government borrowing involves an increase in the demand for money and leads to an increase in the rate of interest

-a higher interest rate in turn can lead to crowding out of private investment

-this means that the government's expansionary fiscal policy is weakened since a greater G is counteracted by a lower I