ECO 120 Macroeconomics Week 7 Fiscal Policy Lecturer Dr. Rod Duncan

Topics Definition of fiscal policy How fiscal policy works Limitations to fiscal policy Crowding out Government debt

Fiscal policy “Fiscal policy” is the government operation of government spending (G) and taxes (T). Typically we consider the problem of how the government can manipulate G and T so as to control economic variables such as output, inflation, interest rates, etc. Issues: how fiscal policy can “stabilize” the economy? what about government borrowing and public debt?

Definitions Budget deficit: the budget deficit is the extent of overspending by the government Budget deficit = G – T Expansionary fiscal policy: increasing the budget deficit (G↑ or T↓) usually in a recession. Contractionary fiscal policy: decreasing the budget deficit (G↓ or T ↑) usually in an economic boom.

Budget deficits and surpluses If the government spends more than it brings in in taxes, what happens? (G > T) The money has to come from somewhere. For developed countries, this means borrowing (issuing government debt or “public debt”) from domestic residents or foreigners. If the government is spending less than it brings in in taxes, the government can reduce public debt. The Australian government has followed this policy in the last 10 years.

Types of fiscal policy We differentiate two types of fiscal policy: Discretionary fiscal policy: This is fiscal policy that comes about from planned changes in G and T that the government brings in in response to the economic situation. Non-discretionary fiscal policy: This is fiscal policy that comes about from the design of spending and taxes. There is no government official actively determining these changes.

Non-discretionary fiscal policy Certain parts of our spending and taxes automatically increase demand in a recession (when AD < potential GDP) and decrease demand in a boom (when AD > potential GDP). Welfare spending and unemployment benefits are part of G and increase in a recession and decrease in a boom. Income and company taxes are part of T and depend on GDP, they increase during a boom and decrease during a recession. These act as “automatic stabilizers” on the economy, reducing the variability of the economy.

Stabilizing a recession In a recession, current output is below the natural or potential rate. We need policies to shift the AD curve right: Increasing government spending Cutting taxes to increase disposable Y. P AS AD Y0 Yn Y

Example Fiscal policy to stabilize a recession Increase G Decrease T

Stabilizing a boom In a boom, current output is above the natural or potential rate. We need policies to shift the AD curve left: Decreasing government spending Raising taxes to decrease disposable Y. P AS AD Yn Y0 Y

Example Fiscal policy to stabilize a boom Decrease G Increase T

Cyclically-adjusted budget deficits The automatic stabilizers raise the budget deficit in a recession and lower the budget deficit in a boom. This fact means that we can not just look at the budget deficit to determine whether the government is “overspending”, we also have to take into account where we are in the business cycle. Adjusting the budget deficit for the point we are in the business cycle is called “cyclically adjusting”. We would expect even a “sensible” government to be in a deficit in a recession.

Discretionary fiscal policy Discretionary fiscal policy is the manipulation of G and T by government officials typically to reduce the severity of shocks to the economy. It sounds like a good idea, but how does it work in reality? There are many problems and limitations to the use of fiscal policy to reduce recessions and booms.

Stabilizing through fiscal policy We would want to achieve the same effects that the automatic stabilizers achieved: raise C and G in a recession and lower C and G in a boom. Recession: lower taxes to raise disposable Y and raise C, and raise G. Boom: raise taxes to lower disposable Y and lower C, and lower G. In recession, government should go into budget deficits. In booms, governments should run budget surpluses.

Problems with discretion Scenario: Imagine a train driver that has only one control- an accelerator/brake that he or she can push or pull on to control the train. This is exactly the same situation as the government faces with fiscal policy. Now what limitations can the train driver face?

Train driver scenario Now Output Time

Problems with discretion Limitations: Correctness of data: Is the train driver seeing the tracks correctly? Or Does the government get the right data about where the economy is? Timing of data: Is the train driver seeing the tracks with enough time to react? Or Does the government get the statistics quickly enough to do anything? Decision lags: Can the train driver make a decision about the correct action before the train reaches the problem spot? Or does the government have time to design the correct fiscal policy?

Problems with discretion Administration lags: If the driver pulls on the control, how long will it take for the brakes to start to work? Or New spending and taxes have to be passed through parliament, which takes time, even after a decision is made. Operational lags: If the brakes start to work, how long before the train slows down? Or New government spending and taxes take time to affect the economy. So even the best-designed fiscal policies can go wrong if they are in response to the wrong data or if they take too long to affect the economy.

Political considerations There are further concerns we might have about the operation of fiscal policy. Politicians have to remain popular. No one likes taxes, and everyone likes new spending on themselves. Will a politician make an unpopular decision that may result in them losing the election if it is the best decision for the economy. Electoral cycles: Governments have to be re-elected every 3-4 years. So a politician would love to engineer a boom right before his or her election.

Crowding out Another problem with fiscal policy is that an increase in G may increase output but at the expense of other components of aggregate expenditure. Y = C + I + G + NX Since the economy returns to potential GDP over the long-run, an increase in G must come at the expense of either C, I or NX or all 3. If an increase in G reduces investment spending over the long-run, this could lead to lower future growth in the economy.

Crowding out How can this happen? An increase in G shifts the AD curve to the right. This results in higher Y and higher P. The increased government borrowing in the market for savings raises the interest rate. Higher interest rates lead to lower investment spending so I drops, shifting AD left. Higher interest rates leads to an appreciation of the A$ (as foreign investors put their money in Australia), so NX drops, shifting AD left.

Example Increase in G Leads to a rise in interest rates Leads to lower I

Government debt One problem that economic commentators always point to is the level of government debt- “Our debt is too high.” How do we evaluate the level of government debt? How do we know is it is “too high”. Government debt is like any other form of debt. You evaluate the debt relative to the income/wealth of the person incurring the debt. A $500,000 debt might be high to you and me, but it might mean nothing to Kerry Packer.

Government debt So we need to evaluate government debt relative to “government income”. But what is the appropriate form of “government income”, as the government doesn’t earn or produce anything. Generally we use the income of the country as the comparison, since the government is free to tax or claim any part of GDP.

Government debt So our criterion for “too much” is debt (B, since typically government debt is issued in government bonds) over GDP (Y): B / Y Banks would make much the same calculation when considering whether to issue someone a home loan. In general debt is growing at the rate of interest each year, r, while GDP is growing at the growth rate of the economy, g.

Budget deficits and debt

Example question Question We start at an initial LR equilibrium using the AD-AS diagram. The Australian government increases G to pay for added security at Australian airports. Carefully indicate what impact this might have on the Australian economy.