Fiscal policy and demand management Learning Outcome: To understand the issues of using fiscal policy to manipulate AD

Fiscal policy and demand management

Learning Outcome: To understand the issues of using fiscal policy to

manipulate AD

The objectives of fiscal policy Fiscal policy is decisions about

government spending, taxation and borrowing

It is an instrument of policy used to achieve 3 main policy goals or objectives To improve macro performance –

used to achieve the four main macro objectives by influencing the demand side of the economy (covered in this section) and the supply side (next section)

To achieve a more desirable distribution of income and wealth

To correct market failure at the micro level

Demand Management Using fiscal policy to manipulate AD

is called Demand Management By reducing tax or spending more

withdrawals will decrease and injections will increase thereby increasing the circular flow of money

This will be further increased by the multiplier effect (according to Keynesians)

This is expansionary fiscal policy – used when there is a negative output gap

The opposite is deflationary fiscal policy reducing AD – used when there is a positive output gap

Automatic stabilisers These automatically increase when

the economy is going into a recession

They automatically fall when national income begins to rise

Government spending and taxation are both automatic stabilisers

When the economy goes into recession and unemployment rises government increases spending on benefits

The fall in AD is therefore less than it would otherwise have been

Tax revenues fall too at a higher rate than the fall in income

This is due to the fact that tax rates tend to be higher on marginal income than on average income

Automatic or built-in stabilisers – mechanisms which reduce the impact of changes in the economy on national income

Automatic stabilisers An example to show you how the

tax falls at a faster rate than the fall in income

A worker paid on commission sells less in a recession

Her tax rate might fall from 40% to 20%

If household spending has to be cut then it is more likely to be on consumer durables taxed at 20% VAT than zero rated goods such as food

With the government collecting les tax disposable incomes are higher and consumption is at a higher level that it would be without the stabiliser


Automatic stabilisers When the economy goes into

a boom Unemployment decreases Government spending falls as

the benefits fall automatically Tax revenue increases at a

faster rate than income An unemployed person will pay

very little tax Once they get jobs they start to

pay substantial amounts of direct and indirect tax

AD is lower than it would otherwise be with these automatic stabilisers


Active or discretionary fiscal policy to manipulate AD

This does not rely on the economy automatically changing the amount of government spending or collecting tax

This is deliberate manipulation of government expenditure and spending to influence the economy

In the 1920s and 1930s the orthodox classical thinking of the day was that governments should maintain balanced budgets whatever the state of the economy

The argument was that for every £1 of government spending would crowd out private sector spending

This would cancel out the affect of the government spending on AD

Active or discretionary fiscal policy – the deliberate manipulation of government expenditure and taxes to influence the economy

Active or discretionary fiscal policy to manipulate AD

Keynes argued that crowding out did not take place in an economy that was in a depression

Post war (50s and 60s) governments used fiscal policy to manage demand

At this time unemployment was low and demand management was just a matter of fine tuning

In the 1970s and 80s they were suffering from high unemployment and high inflation and returned to the crowding out argument

Today the mainstream view is that AD should be manipulated through the use of monetary policy

Fiscal policy is best left to deal with correcting market failure or changing inequality because……

Fine tuning – the attempt by government to move the economy to a very precise level of unemployment, inflation etc

The limitations of using fiscal policy to manipulate AD

Conflicting policy objectives Governments in the past believed that they

could achieve a variety of objectives using fiscal policy

This led to stop-go cycles When the economy was in recession the

government would use expansionary fiscal policy to reduce unemployment and stimulate growth

The economy would overshoot In the subsequent boom inflation would rise

and the BoP would deteriorate Government would put on the brakes and use

deflationary fiscal policy sending the economy back into recession

This was made worse by creating booms around election times

In contrast monetary policy targets only one variable – the rate of inflation

Giving monetary policy to the MPC removes election time manipulation

Stop/go cycle – the movement from boom to recession in the trade cycle


Time lags Assume government announces £500m increase

in civil servant salaries and £500m increase in road building

If the multiplier were 2 this would lead to a £2000m increase in circular flow income (in the Keynesian model)

However this could take years to work through the economy

Salaries might work quickly Road building make take years to even start Government has to take these time lags into

consideration when using fiscal policy to manipulate AD

If it wants to make quick changes it has to change taxes and items of expenditure that have an immediate impact on AD E.g. income tax rates, social security payments

and public sector wages Not road building or hospital building


Time lags Governments have been accused of

destabilising the economy using fiscal policy

If the economy was starting to move into a boom on its own accord and the government at the same time used expansionary policy there would be a positive output gap and inflation

Some economists argue that the inability to predict time lags accurately makes it impossible to use fiscal policy to fine tune the economy


Inadequacy of economic data Active fiscal policy assumes that the

Chancellor knows the current state of the economy

But…statistics are notoriously unreliable

Unemployment and inflation stats are not revised after publication

National income and BoP stats are frequently revised

Often two or more sets of figures which should match fail to do so

If there is a deficit on the BoP the chancellor will not know how much of this is genuine deficit and how much is inaccurate recording of stats

Fine tuning can then be very difficult

• Insert Q3


Inadequate economic knowledge Active fiscal policy assumes that we

know how the economy behaves There is scepticism that economics

will ever be able to predict changes in variables to the last few %

Many of the variables that governments wish to control have very small values

A government may wish to reduce growth from 3% to 1.5%

Fiscal policy is unlikely ever to be sufficiently sensitive to achieve exactly that 1.5% fall


The inadequacy of the model Computer based macro forecasting models used

today are highly complex At best they provide an approximation of

possible outcomes The data (particularly the most recent data) fed

into the models may not be accurate They cannot forecast economic shocks Until the 1980s UK forecasting models failed to

take into account the importance of large changes in house prices for AD

Today there is controversy about the significance of the IT revolution

Some economists say it has improved productivity that is not showing in traditional models

The models are not showing the potential growth without inflation

Others are sceptical and remember the miracle economy of the 1980s created through supply side reforms that led to an overheated economy


Fiscal policy and monetary policy Fiscal policy cannot be independent

of monetary policy If government increases borrowing it

has to be financed Governments can print money to do

this Printing money increases the money

supply and is potentially inflationary Printing money and increasing the

money supply is a monetary policy decision

Hence fiscal policy and monetary policy are interlinked


Fiscal policy and monetary policy Governments can avoid printing money

by borrowing from the private sector This increases the demand for borrowed

funds and interest rates are likely to rise Higher interest rates will reduce the

willingness of the private sector to borrow and spend

The increase in AD from a higher G will to some extent by offset by reduced AD from decrease in I

Allowing interest rates to rise is part of monetary policy and again this shows how monetary and fiscal policy are linked


Fiscal policy and monetary policy Higher government borrowing may not

lead to higher interest rates if the economy is in a deep depression

This is called a Liquidity Trap situation

Liquidity trap – where the economy is in such a deep depression that interest rates have fallen as far as they will ever go. This means that governments cannot use monetary policy through reducing interest rates to stimulate AD. Only fiscal policy can help revive demand


The national debt Since the 2nd WW many governments have

abandoned attempts to balance their budgets

They find it politically easier to spend more than they tax and borrow the difference

The problem is that the borrowing may become very difficult to service (pay the interest)

They may get to the point where the majority of revenue taken in tax is used to pay the interest – they still have to pay the capital

Eventually lenders will be scared that the government will default on its debt

The country may have its credit rating reduced

This will increase the amount of interest the country has to pay on its debt


The national debt In the short term the government

could print money More supply may lead to inflation Inflation reduces the value of the

debt This is not a long term solution Lenders will demand much higher

interest rates if there is high inflation Budget deficits will continue to

increase the size of the national debt


Stability and growth pact When plans were made to create

the European Monetary Union it was recognised that large budget deficits and a sizable national debt could destabilise the economies of individual member countries and therefore the whole union

As a condition of membership the fiscal deficits could not be more than 3% of GDP

The national debt of a country could not be more than 60% of GDP

This stability and growth pact further limits the ability of governments of member countries to use fiscal policy to steer economies


Code for Fiscal Stability In the UK the government has had

its own set of fiscal rules since 1998 The golden rule states that the

government will only borrow to invest (to build hospitals etc) and not to fund current spending (e.g. wages, salaries, rent, heating etc)

The sustainable investment rule states that the national debt will be kept at 40% of GDP

These rules would limit the use of fiscal policy to manipulate AD

Have they kept to these rules recently?

In March 2014, public sector net debt was £1,268.7 billion, equivalent to 75.8% of gross domestic product (GDP).

It has broken its own fiscal stability rule of 40% and the European rule of 60%

The UK national debt is the total amount of money the British government owes to the private sector and other purchasers of UK bonds.

In 2013/14 public sector net borrowing was £107.7 billion (7.4% of GDP)Again it has broken the 3% European rule

Homework

Read Unit 74 (Anderton)Question 5 June 2010The Budget Report of April 2009 estimated that UK

government borrowing for 2009-10 would be £175 billion, or about 12% of GDP.

• Explain possible economic reasons for changes in the level and distribution of government expenditure. (15 marks)

• To what extent should government borrowing be a cause for concern? (25 marks)

First part of the first question - explain reasons for changes in the level of expenditure, e.g.

cyclical: in a recession, for example, welfare spending will automatically increase as more of the population become eligible, but government may also decide to spend more over and above this in order to minimise the recession and initiate a multiplier effect through capital project schemes

new decisions made over the provision of merit goods new decisions made over the provision of public goods to influence the distribution of income changed priorities regarding the drive to reduce poverty and the

general standard of living of the population to underpin key sectors of the economy, e.g. financial services, the

car industry changing taxation revenue allows an increase in, or makes it

necessary to reduce, government spending changing views on government borrowing to finance spending

plans

You would probably only want to explain a couple of these and then the same for the distribution

Second part of first question: explain reasons for changes in the distribution of government expenditure, e.g.

changing economic circumstances, brought about by changing domestic or international conditions, which in addition to changing the level of spending, may cause governments to have to re-distribute spending, e.g. reducing defence spending in order to give more support to domestic sectors of the economy, e.g. banks or postponing capital projects in order to increase welfare payments

the changed priorities of a new government compared to the previous government or a long-standing existing government trying to breathe new life into itself, e.g. action on poverty might cause less spending on transport

demand-determined items of expenditure (perhaps reference to a cyclical/structural distinction)

the impact of an ageing population changing levels of concern internationally over environmental issues

forces the UK government to commit more spending to the problem which could reduce,

for example, the government financial support for the arts/culture etc public or private sector investigations and reports highlight failings in key

parts of the public sector, notably education and the NHS, and these are therefore given priority in spending over defence, for example the topical issue of interest payments on the National Debt

Documents

Fiscal policy and demand management Learning Outcome: To understand the issues of using fiscal policy to manipulate AD