Fiscal policy 1. State Budget 2. Supply Side Economy 3. Government Expenditure Multiplier 4. Tax Multiplier 5. Expansionary Fiscal Policy 6. Crowding Out Effect
Fiscal policy Fiscal Policy is the process of shaping taxation and public expenditures in order to help to reduce business cycle fluctuations and to maintain high economic growth.
State Budget Governments use budget to control and record their fiscal affairs. A budget shows, for a given year, the planned expenditures of government programs and the expected revenues from tax systems.
State Budget State budget revenues: ◦ Tax Revenues: Tax on income, profit and capital gain Property tax Domestic taxes on goods and services (value added tax, excise taxes, road tax)
◦ Non-tax revenues Administrative and other charges and payments Capital income Interest on domestic and foreign credits, loans and deposits ◦ Grants and transfers ◦ Revenues from financial transactions (repayments of credits and loans)
State budget expenditure ◦ Current expenditures Wages, salaries, Insurance premiums and contributions to insurance companies and to the National Labour Office, Current transfers (state social benefits) Payments of interest and other payments in link with loans received Purchases of goods and services ◦ Capital expenses ◦ Expenses in link with financial transactions (credits and loans extended)
Budget Surplus and Deficit Budget Surplus and Deficit A budget surplus occurs when all taxes and other revenues exceed government expenditures. A budget deficit occurs when expenditures exceed revenues. When expenditures and revenues are equal during a given period, the government has a balanced budget.
Structural and Cyclical Budget The structural budget calculates what government revenues, expenditures and deficits would be if the economy were operating at potential output. The cyclical budget calculates the effect of the business cycle on the budget – measuring the changes in revenues, expenditures, and deficits that arise because the economy is not operating at potential output.
Financing Deficit Government can borrow funds from the other sectors of the economy. This involves the selling of government securities such as treasury bonds. Government competes with the private sector for domestic savings, creating what is referred to as a “crowding out effect”. Government supports export. Government sells securities to the central bank. This form of borrowing from the CB basically means that the government prints money to finance the deficit. Government borrows funds from international financial markets. If government borrows funds from overseas it can reduce the crowding out effect.
Fiscal Policy Instruments Automatic stabilizers act to reduce business-cycle fluctuations. Discretionary fiscal policy is one in which government changes tax rates or spending programs. In contrast to automatic stabilizers, discretionary policies generally involve passing legislation to change the structure of the fiscal system.
Automatic Stabilizers Progressive taxes – the average tax rate rises as income rises. In inflationary times, an increase in tax revenues will lover personal income, dampen consumption spending, reduce aggregate demand, and slow the upward spiral of prices and wages.
Automatic Stabilizers Unemployment insurance, welfare and other transfers are designed to supplement incomes and relieve economic hardship. Subsidies on production in the farm sector.
Discretionary Fiscal Policy Public works include public investment projects designed to create jobs for the unemployed. Those projects are highly capital- intensive and long-duration ones. Public employment projects are designed to hire unemployed people for periods of a year or so, after which people can move to regular jobs in the private sector.
Discretionary Fiscal Policy Varying tax rates can be used to either stimulate or restrain an economy. Once taxes have been changed, consumers react quickly; a tax cut is spread widely over the population, stimulating spending on consumption goods.
Supply Side Economy Toward the end of the 1970s, critics of the conventional approach to macroeconomics argued that economic policy had been too oriented toward the management of aggregate demand. New school of supply side economics proposed large tax cuts to reverse slow economic growth and slumping productivity growth.
Supply Side Economy Three central features of supply side economics: ◦ Retreat from Keynesian demand-management policies; ◦ Emphasis on incentives and supply effects; ◦ Advocacy of large tax cuts
Laffer Curve Forbidden zone Tax Rate 100% 0 Tax Revenues A B C D t1t1 t2t2 t3t3
Government Expenditure Multiplier The government expenditure multiplier (g) is the increase in GDP resulting from an increase in government expenditures on goods and services. The government expenditure multiplier (g) is the same number as the investment multiplier: Δ GDP = g. Δ G
Government Expenditure Multiplier C + I + G + ΔG C + I + G Q0 Q1Q1 Q2Q2 C,I,G QPQP E1E1 E2E2
Tax Multiplier Tax multiplier (t) is smaller than the expenditure multiplier by a factor equal to the MPC: t = g. MPC Δ GDP = t. Δ T
Tax Multiplier Tax Multiplier C 2 + I + G C 1 + I + G Q0 Q1Q1 Q2Q2 C,I,G QPQP E1E1 E2E2
Expansionary Fiscal Policy When the economy is operating under the potential output, in the short-run, rightward shift of AD curve has effect on real output with only a small effect on prices. Q P AS AD AD 1 QPQP Q Q1Q1 E E1E1 P P1P1
Expansionary Fiscal Policy Lung-run expansionary fiscal policy, will primarily raise prices and nominal GNP with no effect on real GNP. Q P LRAS = Q P AD AD 1 QPQP 0 E E1E1 P P1P1
Restrictive Fiscal Policy Restrictive fiscal policy includes: ◦ Reduction in government spending ◦ Reduction in trasfer payments ◦ Higher tax rates In the long run reduction in government spending can lead to higher business investment, that will replace this reduction.
Crowding Out Effect The crowding out hypothesis: government spending reduces private investment. When government spends people's money on public works projects these funds simply crowd out private investment.
Complete Crowding Out Effect C + I + G 1 C + I 1 + G 1 Q0 Q Q1Q1 C,I,G QPQP E E1E1 C + I + G
Complete Crowding Out Effect The government enacts a spending program, increasing government spending on goods and services from G to G 1. As a result we have the new C + I + G 1 line. If there were no monetary reaction, GNP would rise from Q to Q 1. Because of the monetary reaction, interest rates rise and reduce investment to I 1. The monetary reaction is so powerful that the new spending line is C + I 1 + G 1 with a new equilibrium level of output, which is exactly the old equilibrium E.