Fiscal Policy

The government directly controls its own expenditure and can thereby directly affect aggregate demand. The government controls the tax levels and therefore they can indirectly impact the spending of households that pay taxes. –Expansionary policy: Increase spending, cut taxes. –Contractionary policy: Decrease spending, raise taxes

Sources of Revenue HK 2004/2005

HK Government Outlays by Category 2005/06

Stabilization policy In an economy subject to shocks to aggregate demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism. However, if this self-correction mechanism takes a long time to work, then government may use policy to speed adjustment. –Use expansionary policy to close a recessionary gap –Use contractionary policy to close an inflationary gap

P Y Y*Y* AD Demand Driven Recession w/ Counter-cyclical fiscal policy P*P* SRAS YPYP AD ′ Economy in LT equilibrium 2.Demand shifts in 3.Government increases spending to shift the AD curve back 3 Recessionary Gap

P Y Y*Y* AD Demand Driven Expansion w/ Counter-cyclical fiscal policy P*P* SRAS YPYP AD ′ Economy in LT equilibrium 2.Demand shifts out 3.Government cuts spending to shift the AD curve back 3 Inflationary Gap

US Recessions are becoming shorter as stabilization policies were adopted.

Lags and Fiscal Policy Administrative lags for fiscal policy may likely be large. Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming. If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.

Automatic Stabilizers Taxes are usually collected as a fraction of incomes of households. Even if the government keeps the tax rate unchanged. –When the economy goes into a boom, taxes are automatically raised mitigating the effects of the boom. –When the economy goes into a recession, taxes are automatically cut, ameliorating the recession.

Budget Deficit Governments in most economies issue debt to make up for shortfalls in revenues in relation to spending. Budget Deficit = Expenditures – Taxes Tax collection is cyclical so the budget deficit tends to be counter-cyclical. Maintaining a balanced budget over the cycle means raising taxes in a recession an cutting taxes in a boom which makes the business cycle more extreme.

Procyclical Budget Surplus in HK

Most Economies Have Positive Government Debt.

Hong Kong Has Traditionally had negative Debt.

Why would a persistent deficit be a problem? Two Reasons 1.High government borrowing may push up interest rates and crowd out investment 2.High government borrowing means that the interest obligations of the government will rise.

Example: US Government runs a deficit to finance military spending S I LF r* LF* r r** S´S´ LF**

Problem Compare budget deficit in a globalized economy with deficit in closed economy. What are the differences in impact on investment and real interest rates?

Budget Surplus in USA (as a % of GDP)

Government Interest Payments per US Resident

Learning Outcomes Students should be able to: Explain the uses of counter-cyclical fiscal policy in stabilization. Explain the effect of budget deficits on real interest rates on capital markets. Explain the negative effects of long-term budget deficits.