Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited Fiscal Policy CHAPTER ELEVEN

© 2004 McGraw–Hill Ryerson Limited Understand why the federal government’s revenue depends on the rate of taxation, the size of the GDP, and its own spending Explain the pros and cons of a budget policy aimed at achieving –full-employment equilibrium –a balanced budget in each fiscal year –both full employment and a balanced budget over the life of the business cycle Discuss the cause, size and problems of the national debt This Chapter Will Enable You to:

© 2004 McGraw–Hill Ryerson Limited Fiscal Policy and the Budget (I) Fiscal policy –The government’s approach toward its own spending and taxation Budget balance –Is the difference between net tax revenues and government spending (NTR – G) Net tax revenue –Total tax revenue received by government less transfer payments NTR = tax revenue – transfer payments

© 2004 McGraw–Hill Ryerson Limited Fiscal Policy and the Budget (II) Budget deficit –Government spending on goods and services in excess of net tax revenues Budget surplus –Net tax revenue in excess of government spending on goods and services National debt –The sum of the federal government’s budget deficits less surpluses

© 2004 McGraw–Hill Ryerson Limited Changes in the Economy and Government Revenues (I) G G, NTR Surplus: NTR  G NTR Deficit NTR < G Real Y

© 2004 McGraw–Hill Ryerson Limited Changes in the Economy and Government Revenues (II) Balanced budget –The equality of net tax revenues and government spending on goods and services Monetizing the debt –The action by government of borrowing from the central bank to finance increased spending

© 2004 McGraw–Hill Ryerson Limited Counter-Cyclical Fiscal Policy (I) Deliberate adjustments in the level of government spending and taxation in order to close recessionary or inflationary gaps A policy used by governments in many countries since World War II

© 2004 McGraw–Hill Ryerson Limited Counter-Cyclical Fiscal Policy (II) Dealing with a recessionary gap by means of fiscal policy, i.e., by raising G and/or lowering T. The gap is equal to YF E minus Y1. Dealing with a recessionary gap by means of fiscal policy, i.e., by raising G and/or lowering T. The gap is equal to YF E minus Y1. YF E Y1Y1 P Real Y AD 1 AD 2 AS 1 Potential GDP Figure 11.2

© 2004 McGraw–Hill Ryerson Limited Counter-Cyclical Fiscal Policy (III) Dealing with an inflationary gap by means of fiscal policy, i.e., by lowering G and/or raising T. The gap is equal to Y 1 minus YF E. Dealing with an inflationary gap by means of fiscal policy, i.e., by lowering G and/or raising T. The gap is equal to Y 1 minus YF E. YF E Y1Y1 P Real Y AD 1 AD 2 AS 1 Potential GDP Figure 11.3

© 2004 McGraw–Hill Ryerson Limited Criticisms of Counter-Cyclical Fiscal Policy effective but subject to serious time lags ineffective because it may be inflationary, crowds out private investment spending and thus reduces the multiplier –The crowding out effect The idea that government borrowing to finance a deficit crowds out private investment because it causes interest rates to rise can cause serious budget deficits

© 2004 McGraw–Hill Ryerson Limited Balanced-Budget Fiscal Policy (I) The belief that a government’s budget should be balanced in each budget period Advocates of this policy use three observations to support their position: 1.Counter-cyclical philosophy adversely affects peoples’ incentives and warps their sense of responsibility

© 2004 McGraw–Hill Ryerson Limited Balanced-Budget Fiscal Policy (II) 2.The economy has effective automatic stabilizers Automatic stabilizers –Government policies and programs that automatically change with the state of the economy so as to stabilize the economy 3.The economy is capable of returning to full- employment equilibrium through a self- adjustment process

© 2004 McGraw–Hill Ryerson Limited Criticisms of Balanced-Budget Fiscal Policy (I) A balanced-budget fiscal policy will likely be pro-cyclical in circumstances in which the economy is experiencing a recessionary gap, since trying to eliminate the resulting budget deficit will lead to an even bigger recession –Pro-cyclical Action by the government that tends to push the economy in the same direction it is leaning in

© 2004 McGraw–Hill Ryerson Limited Criticisms of Bal.-Budget Fiscal Policy (II) This policy will also be pro-cyclical when the economy is experiencing an inflationary gap If the inflationary gap comes with a budget surplus, this policy will also be pro-cyclical

© 2004 McGraw–Hill Ryerson Limited The Arithmetic of a Balanced Budget What would be the impact on GDP of a. A same-amount increase in G and T? b. A same-amount cut in G and T? The answer is NOT “no effect”. The multiplier set in motion by a change in G is larger than the one created by a change in T The answers to the above questions are: a.If +  G = +  T, GDP will rise b.If -  G = -  T, GDP will shrink

© 2004 McGraw–Hill Ryerson Limited Cyclically Balanced-Budget Fiscal Policy The use of counter-cyclical fiscal policy to balance the budget over the life of the business cycle Potential problems: –There is no guarantee that the size and the length of the recessionary gap, when the government is running a budget deficit, will be exactly offset by the size and the length of the inflationary gap when the government is running a budget surplus –Most governments find it easier to increase spending in bad times than to decrease it in good times –The political cycle does not correspond to the business cycle, so that one government might leave the problem of balancing to the next government.

© 2004 McGraw–Hill Ryerson Limited Fiscal Policy and the National Debt (I) The problems with high deficits and debt: –The potential crowding out of private investment spending and net exports –The interest payments that must be paid out on the foreign-held debt –The income redistribution effects of large interest payments –The reduced ability of government to meet the needs of its citizens –The potential inflationary effects

© 2004 McGraw–Hill Ryerson Limited Fiscal Policy and the National Debt (II) Misconceived Problems With The National Debt: –Suggestions that if revenue falls short of expenses for a long period of time, then bankruptcy will follow –Claims that we are encumbering future generations who will eventually have to pay for the debt –Looking at the debt in isolation from Canada’s GDP

© 2004 McGraw–Hill Ryerson Limited Understand why the federal government’s revenue depends on the rate of taxation, the size of the GDP, and its own spending Explain the pros and cons of a budget policy aimed at achieving –full-employment equilibrium –a balanced budget in each fiscal year –both full employment and a balanced budget over the life of the business cycle Discuss the cause, size and problems of the national debt Chapter Summary: What to Study and Remember