1 LECTURE 4 Fiscal Policy

2 The Multiplier Revisited Changes in one or another of the components of total spending C, I, G or NX will change the equilibrium GDP by a larger amount. Fluctuations in any of these - C, I, G or NX occur all the time. If the multiplier is smaller, GDP will be less sensitive to such shocks; that is, the economy will be less volatile.

3 Automatic Stabilizers Features of the economy that reduces its sensitivity to shocks are called automatic stabilizers. Example: Income tax. It acts as a shock absorber because it makes disposable income, and thus consumer spending, less sensitive to fluctuations in GDP.

4 Income Tax as an Automatic Stabilizer Suppose Firm A spends RM1 million on salaries. Assume that the government levies a 20% income tax. This means that workers only receive RM800,000 in after-tax income (also known as disposable income). If MPC is 0.75, spending in the next round will only be RM600,000; which in only 60% of the original expenditure because of the income tax.

5 Built-In Stabilizers A built-in stabilizer is anything that increases the government’s budget deficit (or reduces its budget surplus) during a recession and increases its budget surplus (or reduces its budget deficit) during inflation without requiring explicit action by policymakers.

6 Government Expenditures (G) and Tax Revenue (T) T Surplus G Deficit 0 GDP 1 GDP 2 GDP 3 Gross Domestic Product

7 From the graph above, tax revenues (T) vary directly with GDP, and government spending G is assumed to be independent of GDP. As GDP falls in a recession, deficits occur automatically and help alleviate the recession. As GDP rises during expansion, surpluses occur automatically and help offset possible inflation.

8 Fiscal Policy The government’s fiscal policy is its plan for spending and taxation. The government will take these actions to reach certain goals such as full employment, price stability and economic growth. There are two types of fiscal policy: (a) expansionary fiscal policy. (b) contractionary fiscal policy.

9 Expansionary Fiscal Policy An expansionary fiscal policy is defined as: (a) an increase in government expenditures or (b) a decrease in in taxes. This is done with an aim to increase budget deficit or decrease budget surplus.

10 Contractionary Fiscal Policy A contractionary fiscal policy is defined as: (a) a decrease in government expenditures or (b) an increase in taxes. This is done with an aim to decrease budget deficit or increase budget surplus.

11 Fiscal Policy to Eliminate Recessionary Gap Real Expenditure (RM billions) 45 o Potential GDP C + I + G + NX E Recessionary Gap 0 6,000 7,000 Real GDP (RM billions)

12 Real Expenditure (RM billions) 45 o Potential GDP F C + I + G + NX C + I + G + NX 0 6,000 7,000 Real GDP (RM billions)

13 Problems and Critiques of Fiscal Policy Problems of timing Political considerations Future policy reversals Offsetting state and local finance Crowding-out effect

14 Problems of Timing Recognition lag (a) This is the time between the beginning of recession or inflation and the certain awareness that it is actually happening. (b) It arises because of the difficulty in predicting the future course of economic activity. Administrative lag There will typically be a significant lag between the time the need for fiscal action is recognized and the time action is taken. Operational lag A lag also occurs between the time fiscal action is taken and the time that action affects output, employment, or the price level.

15 Political Considerations A strong economy at election time might politicians. Eg. Politicians might favor large tax cuts under the guise of expansionary fiscal policy even though that policy is economically inappropriate.

16 Future Policy Reversals Fiscal policy may fail to achieve its intended objectives if households expect future reversals of policy. Eg. Tax cuts. If taxpayers believe the tax reduction is temporary, they may save a large portion of their tax saving, reasoning that rates will return to their previous level in the future.

17 Offsetting State and Local Finance The fiscal policies of state and local governments are frequently pro-cyclical, meaning that they worsen rather than correct recession or inflation.

18 Crowding-Out Effect An expansionary fiscal policy (deficit spending) may increase the interest rate and reduce private spending, thereby weakening or canceling the stimulus of the expansionary policy. In this view, fiscal policy may be largely or totally ineffective!