Fiscal Policy & Aggregate Demand A2 Economics Presentation 2005

Fiscal policy and aggregate demand Traditionally fiscal policy has been seen as an instrument of demand management Fiscal policy can be used “counter-cyclically” to help smooth out some of the volatility of output From 2001-2004 there has been a huge fiscal stimulus to the UK economy through substantial increases in government spending on transport, health and education The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment, particularly when the economy is operating well below full capacity national output

Setting the fiscal stance For a government, there are two main issues in setting fiscal policy: what should be the overall stance of policy, and what form should its individual parts take? Some economists and policymakers argue for a balanced budget Others say that a persistent budget deficit (public spending exceeding revenue) is acceptable provided, in accordance with the golden rule, the deficit is used for capital investment (for example in building new infrastructure, say) rather than simply being used to stimulate household consumption. However, there may be a danger that public-sector investment will result in the crowding-out of more productive private investment.

Negative output gap LRAS General Price Level P1 P2 AD1 SRAS AD2 Y2 Y1 Yfc National Income

Automatic and discretionary changes in fiscal policy Discretionary fiscal changes are deliberate changes in direct and indirect taxation and govt spending Automatic fiscal changes are changes in tax revenues and government spending arising automatically as the economy moves through stages of the business cycle Automatic stabilizers help to reduce the volatility of the business cycle A fast-growing economy tends to lead to a net outflow of money from the circular flow Conversely during a slowdown or a recession, tax revenues fall and the government automatically injects extra welfare spending into the economy and normally ends up running a larger budget deficit. According to recent work by economists at the OECD, if the government allows the automatic stabilizers to work, the amplitude of the business cycle can be reduced by over 20%

Impact of automatic stabilisers on the economic cycle Effectiveness of automatic stabilizers in large EU countries Percentage of fluctuations in output that are smoothed Consumption Investment Export Productivity shock Germany 17 9 10 13 France 23 14 Italy 21 11 12 UK 18 8

The fiscal policy transmission mechanism Cut in personal income tax Boost to disposable income Adds to consumer demand Cut in indirect taxes Lower prices – higher real incomes Adds to consumer demand Expansionary Fiscal Policy Adds to business capital spending Cut in corporation tax Higher “post tax” profits for businesses Cut in tax on interest from saving Boost to disposable income of people with net savings Adds to consumer demand

Problems in using fiscal policy to manage aggregate demand Recognition lags and policy time lags It takes time to recognise & implement an appropriate policy response It takes time for the policy to work The importance of the national income multiplier – imperfect information Without knowing the precise value of the multiplier it is difficult to fine-tune the economy accurately. Fiscal Crowding-Out To finance a deficit the government will have to sell debt to the private sector – this may require higher interest rates Reaction to Tax Cuts The ‘rational expectations’ view - when the government runs a large deficit, then a rational individual will realize that at some future date he will face higher tax liabilities. Thus, he should increase his savings

Fiscal policy and aggregate supply Labour market incentives: Cuts in income tax / higher allowances might be used to improve incentives for people to seek work and also as a strategy to boost labour productivity Capital spending. Lower rates of corporation tax and other business taxes might be used to stimulate a higher level of business investment Entrepreneurship and new business creation: Government spending might be used to fund an expansion in the rate of new small business start-ups and to attract inflows of foreign direct investment Research and development and innovation: Government spending, tax credits and other tax allowances could be used to encourage an increase in business sector research and development Human capital of the workforce: Higher government spending on education and training (designed to boost the human capital of the workforce) and increased investment in health and transport can also have very important supply-side effects

The European Fiscal Stability Pact The fiscal stability and growth pact (FSG) was invented in 1996 to make European fiscal policy sustainable The pact imposes a 3% ceiling on government budget deficits as a % of GDP Over the medium term, European Government must seek to balance their budgets The European Commission can impose cash fines if the budget deficit limits are breached This more or less rules out the use of fiscal policy to deliver a huge fiscal stimulus to an economy

Criticisms of the fiscal stability pact European economies that can no longer set their own monetary policy need more scope than in the past to let fiscal policy play a role in stabilising economies and smoothing the effects of cyclical volatility ‘Built-in fiscal stabilizers’, i.e. the automatic decline in taxes and increase in welfare benefits in a recession can help to achieve this The flexibility that governments have to use fiscal policy to manage demand is limited Governments have to balance their budgets over the medium term Budget deficits may not exceed 3% of GDP The risk is that slower growth has squeezed tax revenues and swelled budget deficits, the stability pact is forcing governments to tighten fiscal policy just as their economies move towards recession