2.4 Fiscal Policy

Fiscal policy is one of the key macroeconomic tools of the government. Fiscal

policy involves the use of government expenditure and taxation to influence the economy. Keynesian economists tend to concentrate on the effects that Fiscal Policy has on AD, whilst Classical/Supply-Side economists also look at the effect that Fiscal Policy has on AS. 

Fiscal Policy and AD. 

A rise in government expenditure, or a fall in taxation, should increase aggregate demand and boost employment. The size of the resulting final change in equilibrium national income is determined by the multiplier effect. This is where an initial increase in expenditure leads to a higher overall increase in income, as people pass on the money (this is studied in detail at HL).

Automatic Stabilisers and Discretionary Fiscal Policy

Automatic stabilisers describe what happen to Government expenditure and taxation, when there are changes in the economic cycle, even though the Government does not change any of its policies. For example, when in a recession we expect to see a rise in government spending (transfer payments) and a fall in tax revenues, which would reduce the impact of the economic slowdown. Likewise, during a boom, the tax system takes a rising share of national income from households and companies (in part this is because of the progressive system of direct taxation). When demand and incomes are increasing, the government will see a strong flow of extra tax revenue - money that leaves the circular flow of income and spending. Discretionary or active fiscal policy refers to the deliberate changing of government policy which expenditure levels and tax rates. The government might decide to boost government spending and run a budget deficit in a clear attempt to inject extra aggregate demand into the economy and boost short-term growth.

Problems with the use of fiscal policy when managing aggregate demand

In simple economic theory the economic cycle can be managed by

fiscal policy. However, in reality the situation is far more complex. Why?

• Time lags. It takes time to recognise that AD is growing either too quickly or too slowly. It then takes time to introduce an appropriate policy.It takes time for the policy to work, as the multiplier process is not instantaneous.

· the national income multiplier. Suppose a government wanted to eliminate a deflationary gap of £1000m. The increase needed in government expenditure will depend on the size of the multiplier. The problem lies in knowing the exact size of the multiplier. If the multiplier is 2, then government expenditure would have to rise by £500m. However, if the multiplier was 4, a rise of only£250m would be needed. Without knowing the precise value of the multiplier it is difficult to fine-tune the economy accurately.

• Fiscal Crowding-Out If the government attempts to reflate the economy by reducing taxation, or by increasing government spending, then this may lead to a budget deficit. To finance the deficit the government will have to sell debt to the private sector. Attracting individuals and institutions to purchase the debt the government may have to increase interest rates. This rise in interest rates may “crowd out” (reduce) private investment and consumption and reduce the fiscal stimulus to the economy. Also if people are buying bonds then there may not be sufficient funds for the private sector to borrow. In reality in modern economies, with sophisticated international financial markets, it is unlikely that firms will not be able to gain finance, so this effect is not particularly strong. (How has this last sentence changed in 2008-9? Firms are finding it difficult to gain finance)

What does the following data from 2011 show us?

Government bond yields (in effect the interest rate paid on bonds)

• German 10yr Yield: 3.30%

• Spanish 10yr Yield: 5.46%

• Portuguese 10yr yield: 7.66%

• Irish 10yr Yield: 9.15%

• Greek 10yr Yield: 11.55%

Public Sector Finances - Government Borrowing and Debt Repayment

The Public Sector Net Cash Requirement (PSNCR) is the financial

deficit of the Government. When the government is running a budget deficit it means total public expenditure exceeds revenue. As a result, the government has to borrow through the issue of government debt (bonds). It is also sometimes referred to as the Public Sector Borrowing Requirement (PSBR) or Budget deficit. When the Government has more revenue than it spends it is able to reduce its debts by using the excess revenue to buy back some of the bonds. It is therefore referred to as the Public Sector Debt Repayment (PSDR). None of the above should be confused with the term “National Debt” which is something different! The national debt is the total borrowing undertaken by central government, which has not yet been repaid. In other words, it is the sum of all outstanding government debt. Eg If the Government has the following PSBRs calculate the National Debt

• Yr 1 PSBR 100 rmb

• Yr 2 PSDR 40 rmb

• Yr 3 PSBR 60 rmb

National Debt=

U.S. to Pay Down $35 Billion in National Debt in Q2

National debt video link 

Note figures above are debt as a % of gdp

Does it matter if the government is running a large budget deficit?

There is a general agreement amongst economists that a persistently large budget deficit can be a major problem for the government and the economy:

It has to be financed

Issuing government debt to domestic or overseas investors can do this. In a world where money flows freely between countries it can be relatively easy to finance a deficit - but it may require higher interest rates to attract buyers of debt. This in turn will have a negative effect on economic growth. In 2009 this has become a major issue. National debts are increasing significantly and it is being questioned whether some countries can actual finance these. Once the market feels that a country cannot finance its deficit then it is harder for Governments to sell bonds. 

Would you buy Government bonds from Iceland at the moment???

In the long run, a high PSNCR adds to the accumulated National Debt. 

This means that the Government has to pay more each year in debt interest charges. There is an opportunity cost here. That spending could be used in more productive ways. 

It also represents a transfer of income from people who pay taxes to those who hold government debt. A high PSNCR may therefore cause a redistribution of income and wealth in the economy. This is controversial at the moment. Much Government expenditure is going to help Banks who made losses due to incompetence and greed.(?) Future generations of taxpayers are bailing them out? Fair?

"Today's borrowing is tomorrow's taxes"

Eventually the deficit has to be reduced. This can be achieved by cutting public sector spending, but the normal way is to increase the tax burden.

Many countries have been implementing so called "austerity policies to try and reduce the National Debt. Watch this video 

However there are circumstances in which it could be argued that a budget deficit is not a problem:

Keynesian theory argues that a PSNCR is a stimulus to AD - something that might be necessary in a deep recession or economic slump. However if the Government is running a PSNCR in a boom, then there maybe something fundamentally wrong.

US National debt be prepared for a surprise!

Many now see it as an objective to balance the budget over the economic cycle.

Government Borrowing and Asset Accumulation

A PSNCR may have positive effects in the long run if it is being used to finance capital spending that leads to an increase in the productive potential of an economy. Again there has been a big debate about this in China. Due to the world recession in 2009 the Chinese Government implemented one of the largest fical stimulus programmes ever seen. But was this efficient investment or was it simply leading to huge amounts of spare capacity in industries where consumers were disinterested in purchasing their output. (was the Shanghai expo worthwhile would be a good debate on this- many buildings were simply demolished after the Expo finished but we still have a vastly improved metro system (underground). This is not just restricted to China. Spending on the infrastructure improves the supply-side capacity of the economy promoting long-run economic growth. However if excess spending is wasted on non productive projects then there will be no returns on this spending in the future. Do bailouts by the US government to AIG to allow them to pay bonuses to bosses really lead to promoting long term economic growth? 

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