Fiscal Policy Use of budgetary actions to try to “stimulate the economy” or “control inflation” FP involves changes in taxation and government spending to influence economic activity Can be discretionary or non-discretionary

Fiscal policy Control inflation and Encourage economic growth Objectives of fiscal policy are to: Achieve full employment Control inflation and Encourage economic growth Instruments of fiscal policy are government spending tax collections

Expansionary fiscal policy When economy is in a recession or suffering from cyclical unemployment, the government may use Fiscal Policy to try and stir it to full-employment level of output. It can do this by: Increasing government spending Shifts aggregate demand to the right by more than the initial increase in government spending. Why? Reducing taxes Using some combination of the two

Increased government spending & tax cuts Government may respond to a recession by spending G (ΔG) on education, roads, public works etc. If government budget is initially balanced, it will move to a deficit, explain (pp. 436)! This will increase equilibrium GDP by more than ΔG, i.e., ΔGDP = ΔG x multiplier; use question 2Aiii in test 1 and figure 11.1 to illustrate the multiplier effect This pushes the economy out of the recession and also reduces unemployment as firms increase their employment to the full-employment level Government may reduce taxes instead. This shifts AD rightward. A tax cut initially raises consumption by mpc x ΔT. But the ΔC triggers the multiplier process yielding successive rounds of increased consumption spending. Government may combine the two alternatives above

Contractionary Fiscal policy Contractionary FP can be used to control demand-pull inflation. It may do this by; decreasing government spending Shifts aggregate demand to the left by more than the initial increase in government spending. Why? Increasing taxes Using some combination of the two

decreased government spending & tax increases Government may respond to demand-pull inflation by reducing spending G (ΔG). If government budget is initially balanced, it will move to a surplus, explain! This will reduce equilibrium GDP by more than ΔG, i.e., ΔGDP = ΔG x multiplier; use question 2Aiii in test 1 and figure 11.2 to illustrate the multiplier effect Theoretically this brings the price level down to the full-employment level Government may increase taxes instead. This shifts AD leftward. A tax increase initially lowers consumption by mpc x ΔT. But the ΔC triggers the multiplier process yielding successive rounds of reduced consumption spending. Government may combine the two alternatives above

Policy options: G or T? Economists tend to favor higher G during recessions and higher taxes during inflationary times if they are concerned about unmet social needs or infrastructure Others tend to favor lower T for recessions and lower G during inflationary periods when they think government is too large and inefficient.

Built-In Stability A built-in-stabilizer is anything that increases the government’s budget deficit (or reduces its budget surplus) during a recession (or reduces its budget deficit) during an expansion without requiring explicit policy action Built‑in stability arises because net taxes (taxes minus transfers and subsidies) change with GDP Taxes automatically rise with GDP because incomes rise and tax revenues fall when GDP falls Transfers and subsidies rise when GDP falls; when these government payments (welfare, unemployment, etc.) rise, net tax revenues fall along with GDP The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built‑in stability

Problems, Criticisms and Complications Problems of timing Recognition lag is the elapsed time between the beginning of recession or inflation and awareness of this occurrence. Administrative lag is the difficulty in changing policy once the problem has been recognized. Operational lag is the time elapsed between change in policy and its impact on the economy Political considerations: Government has other goals besides economic stability, and these may conflict with stabilization policy A political business cycle may destabilize the economy: Election years have been characterized by more expansionary policies regardless of economic conditions “Crowding‑out” may occur with government deficit spending. It may increase the interest rate and reduce private spending which weakens or cancels the stimulus of fiscal policy

Fiscal policy in Botswana Total Revenue (Pm) Total expenditure Pm Overall surplus (+)/Deficit (-) 1996/97 7 394.8 6 092.4 1 302.3 1997/98 8 281.2 7 406.1 875.1 1998/99 7 677.6 9 065.4 -1 387.8 1999/00 11 963.1 10 427.5 1 535.6 2000/01 14 115.1 11 536.5 2 578.6 2001/02 12 708.9 13 670.9 -962.0 2002/03 14 318.3 15 710.1 -1 391.8 2003/04 16 197.3 16 275.6 -78.3 2004/05 17 956.6 17 382.6 574.0 2005/06 22 266.6 17 631.9 4 634.8 2006/07 27 397.7 19 737.4 7 660.3 2007/08 28 629.4 24 821.8 3 807.6 2008/09 30 455.1 35 150.7 -4 695.6 2009/10 30 023.1 39 489.2 -9 466.1 2010/11 31 909.4 38 417.4 -6 508.0 2011/12 37 994.2 41 753.3 -3 759.1

Current thinking on fiscal policy Some economists oppose the use of fiscal policy, believing that monetary policy is more effective or that the economy is sufficiently self-correcting. Most economists support the use of fiscal policy to help “push the economy” in a desired direction, and using monetary policy more for “fine tuning.” Botswana follows a Fiscal Rule which requires that G not exceed 40% of forecast GDP

Summary MP & FP Monetary policy Fiscal Policy Objectives Instruments Impact Achieve full employment OMOs Aggregate demand Control inflation Interest rate regulate economic growth Legal reserve requirement ratio Objectives Instruments Impact Achieve full employment Government spending Tax collections Aggregate demand Control inflation regulate economic growth

Summary MP & FP Monetary policy Fiscal Policy Problem Instruments Policy type Unemployment/slow growth/recession Interest rate; OMOs; Legal reserve requirement ratio Expansionary Inflation Contractionary Problem Instruments Policy type Unemployment/slow growth/recession Government spending; Tax collections Expansionary Inflation Contractionary

Summary MP & FP Monetary policy Fiscal Policy Problem Instruments action Unemployment/slow growth/recession OMOs; Bank rate (i); Legal reserve ratio (R) Buy government bonds from households & Comm banks; Increase i; Increase R Inflation Bank rate; Legal reserve ratio Sell government bonds to households & Comm banks; lower i; Lower R Problem Instruments Action Unemployment/slow growth/recession Government spending (G) Increase G Tax collections (T) Lower T Inflation Government spending Reduce G Tax collections Increase T

Some Questions What is fiscal policy? What are the objectives/goals of fiscal policy? Discuss any two instruments of fiscal policy? Distinguish between expansionary fiscal policy and contractionary fiscal policy. An economy suffers from hyperinflation. Which fiscal policy would you use and why?