M ACROECONOMIC P OLICY IN THE A SIA -P ACIFIC GECO6400 Fiscal Policy

MACROECONOMIC POLICY IN MACROECONOMIC POLICY IN THE ASIA-PACIFICTHE ASIA-PACIFIC

GECO6400GECO6400

Fiscal PolicyFiscal Policy

The Public Sector Fiscal Policy explained Fiscal Policy and the Aggregate Expenditure Model The Government Budget Discretionary Fiscal Policy Non-Discretionary Fiscal Policy Budget Outcomes Public debt. Offer an evaluation of efficacy of fiscal policy. We will compare budget outcomes in various

countries.

FISCAL POLICYFISCAL POLICY

All entities owned &/or controlled by Federal, state or local governments

The Public Sector forms the 3rd macroeconomic sector in the circular flow of income. The macroeconomy is no longer a private macroeconomy but a public one.

The public sector is made up of all levels of government (federal, state and local) and government institutions and enterprises. They have a significant impact on macroeconomic activity.

The federal government has the greatest impact due to its size and scop of operations and influence, both financially and legislatively.


The Public sector generally fulfills three broad functions within an economy:

1.Resource Allocation Dealing with externalitiesFunding public goods (health, education, defence etc.)Regulating natural monopolies (railways, water and electricity supply and pricing)


2. Income Redistribution minimum standard of living (transfer

payments such as disability pensions, UB, etc).

Taking from the better-off citizens and giving it to the less well-off through progressive income tax, capital gain tax etc.

3. Output Stabilisation Aim to facilitate growth and reduce the

amplitude of business cycle simultaneously. Stabilisation goals (inflation & unemployment)

Government expenditure has multiplier effect


The Public Sector and Fiscal Policy

Fiscal policy is the Public Sector’s management of its revenue and expenditure.

It is the financial side of policy implementation.

The government has at its disposal the taxes it collects and debt it raises to spend.

It then uses these to finance its expenditure programs.

In this Lecture we are concerned with Stabilisation Policy only and not with Allocation or Income distribution functions of the Government


The Federal Budget sets out the expected revenue and expenditure flows within a period of time.

Reviews the past performance of the economy.

Forecasts the key macroeconomic variables.

Sets out the policy changes and their policy implications


The budget outcome is calculated as:Revenue - Expenditure

Tax revenue:Lump sum taxes (e.g poll tax)proportional taxes (GST)progressive taxes (income taxes).

Federal Government Expenditure:Current expenditure.Capital expenditure.Transfer payments (aged pensions, current transfers and grants to the states).


Government expenditure is treated like Investment & Export expenditure (injection into the economy).

AE=C+I+GTaxation is treated like Saving and Imports (leakage out of the economy).

Leakages=S+TInjections=I+G


Government Expenditure (G)Government Expenditure (G)G is assumed autonomous since it is a function of Budgetary Policy decisions.

General Form: G= GANumerical Example: G = 1000

Tax Revenue (T)Tax Revenue (T)T are partially induced since income taxes are function of Real GDP (Y).

General Form: T=TA + tYwhere: TA = lump sum taxes

t = marginal tax rateNumerical Example: T = 200 + 0.4Y


Government Expenditure and Taxation can be represented on the leakages-injections diagram (similar to Investment and Savings)

T=200+0.4Y

G=$1,000

OUTPUT

G and T

200


Budget OutcomesBalanced Budget: revenue equals expenditure.

G=TSlightly Expansionary. Balanced Budget Multiplier (not

neutral).

Budget surplus: revenue is greater that expenditure.Government earns more than it spends. Government is

saving.G<T

Contractionary.

Budget deficit: outlays are greater than revenue. Government spends more than it earns.

G>TExpansionary.


Taxes are a leakage from the circular flow

Therefore this impacts on the size of the multiplier.

Expenditure multiplier is now 1/MPS+t.

Note, savings are also affected by tax.


G>TBudget Deficit

T>GBudget Surplus

G and T

Real GDP (Y)

G = 10001000

T = 200 + 0.4Y

200

T = GBalanced Budget

-800Budget Outcome

T - G

0


A budget surplus is contractionary in an income-generating sense because the government takes more money out of the Circular Flow of Income than it puts in.

A budget surplus causes economic activity, employment and inflation to decline.


Financing a Budget DeficitThe excess of expenditure over revenue means that a the government needs to source extra funding for its activities.It can do this in 2 ways:

Debt FinancingBy borrowing from the public (getting into debt).

Government borrowing is done by selling IOUs (bonds) to the general public. The buyer of the bonds (the Reserve Bank of Australia or the private sector) determines the nature of the finance obtained.


Monetising the DeficitPrinting more money (via the mint).

When the bank buys bonds from the government, it uses newly-created money to do so.

This newly-created money flows back into the banking system in the form of an increase in the monetary base.

An increase in MS causes an increase in AD.

Higher AD leads to an increase in the price level.


Monetising the DeficitPersistent money financing of a budget deficit leads to continuous increases in AD and to inflation.

This can be more expansionary than debt financing because more money is created and can support more macroeconomic activity.


Monetising the DeficitBUT, the Reserve Bank must accommodate the increased money in the economy by at least maintaining the general level of interest rates; or

This can lead to a rise in inflation (demand-pull).

G increases, but there is no real change in GDP because there is more money but no change in the output of goods and services.


Discretionary Fiscal PolicyThis is the government’s deliberate regulation of its budget to attempt to smooth out business fluctuations (to ensure maximum employment and low inflation).

The government takes advantage of the impact that the budget outcome has on economic activity and uses this to achieve its policy aims.

Policy aims: high economic growth (GDP), low prices (inflation), low unemployment.

Eliminate or reduce Inflationary or deflationary gaps


Deflationary gap: when potential GDP is greater than actual GDP. The government should pursue an expansionary fiscal policy to eliminate the gap.

Inflationary gap: when potential GDP is less than actual GDP. The government should dampen the economy through contractionary fiscal policy.


Types of Budget OutcomesActual: the basic outcome of the budget.

Structural: the budget outcome that would occur at full employment or potential output. The structural budget outcome indicates the type of discretionary fiscal objective being sought by the government.

Cyclical: the actual budget outcome minus the structural budget outcome. This is influenced by economic activity.


The actual budget outcome can be expressed as:BA=BC+BS

The structural budget is achieved at potential GDP. It is calculated as the Actual budget outcome less the Cyclical budget outcome:

BS=BA-BC

The cyclical budget outcome is equal to the actual budget outcome less the structural budget outcome:

BC=BA-BS


Take our example:T=200+0.4Y and G=2000

Now if actual GDP=3000

Actual Budget outcome is:T-G =200+0.4(3000)-2000=1400-2000= -600 ~ deficit

The stance of Fiscal Policy, judging from this budget outcome, looks expansionary.


But let Potential GDP=5000

Structural budget outcome is:T-G=200+0.4(5000)-2000= 2200-2000 = +200 ~ surplus

The stance of Fiscal Policy, judging from this budget outcome, looks contractionary.


The Cyclical budget outcome is:T-G= actual – structural= -600-200 = -800

Actual economic activity is lower that potential economic activity, therefore the government’s taxation revenue falls short of its budgeted level because this is based on potential GDP.

Taking into account the state of the economy, the budget needs to be more expansionary than it actually is.

That is, the government needs to increase its expenditure (G) or reduce taxation (T) to get the economy to its full potential.


AE

SAS

AD

T

G

LRAS

Equilibrium GDP

Budget Deficit

Budget Surplus

YE=$3,000BActual Budget Outcome$600B Deficit

YP=$5,000BStructural Budget Outcome$200B Surplus

Cyclical Budget OutcomeActual-Structural$800B Deficit

3000

3000 5000

Price

Real GDP

Real GDP

AE

Real GDP

T&G

45o


Automatic StabilisersAutomatic stabilisers take some of the discretion out of the budget outcome.

Automatic Stabilisers are institutional factors that are set up by the government for various reasons (such as equity or to provide a revenue base for budgetary activity).

Once they are in place, they act counter-cyclically to influence the outcome of the budget – they influence government revenue and expenses.

Again, the emphasis is on income influencing macroeconomic behaviour in a counter-cyclical way.


Built-in stabilisers that operate without requiring explicit action by policy-makersDuring recessions: Tend to increase government deficits (or reduce surplus)During inflationary periods: Tend to increase government surpluses (or reduce deficits)

Examples of Automatic StabilisersProgressive Income Tax: as income increases, so does the leakage of tax, reducing the impact of increased income on spending.Transfer payments: eg unemployment benefits. As income declines, transfer payments increase, boosting AD and keep the economy buoyant.


-800

Budget OutcomeT - G

As GDP increases the Budget moves from DEFICIT into SURPLUS.

Automatic Fiscal Automatic Fiscal StabilisersStabilisersBudget Outcome

G and T

Real GDP (Y)


Suppose the economy has found equilibrium at less than full employment.

Any attempts to stimulate the economy will be muted by the operation of the automatic stabilisers. This is fiscal drag.

For example, increase Government spending by $300 with multiplier of 2. Change in Ye will be $600 but if MPT = 0.4, then tax revenues will increase & dampen Ye by $240. Cure: Appropriate discretionary fiscal policy


The Actual budget outcome in any given year does not necessarily indicate the government’s true fiscal stance.

The presence of automatic stabilisers means that the actual budget outcomes are sensitive to the level of GDP.

To determine stance (expansion or contraction) of budget look at the Structural budget outcome (what is would be at potential GDP).


PotentialGDP

260280300320340360380400420440

1980 1985 1990 1995 2000

Billion

s of

199

0 do

llar

s

RealGDP


Crowding outCrowding outCrowding out occurs when the government competes with the private sector for funds to finance a budget deficit.

The competition for funds causes an increase in demand for money and hence interest rates.

This slows down growth.


G AE Y MD IR I AE Y

IR D$A ER NX AE Y

Domestic Crowding Out

Overseas Sector:

Fiscal Policy Transmission Mechanism and Crowding OutFiscal Policy Transmission Mechanism and Crowding Out

International Crowding Out


Fiscal Policy Transmission Mechanism and Crowding OutFiscal Policy Transmission Mechanism and Crowding Out

Y1

AE

Real GDP

AE0

Y0

Aggregate Expenditure Model Money Market Investment Demand

IR

QM

IR

ID

IR0

I0 I1

MD0

MS

Y

MD1

AE2

AE1 IR1

Y2 I

G AE Y MD IR I AE


Net Export EffectThe impact of interest rate-induced change in

the exchange rate, and thus net exports, following changes in fiscal policy.

Freely-floating exchange rate system.

Expansionary Fiscal Policy Results in higher interest rates. This increases the demand for the $A leading to its appreciation and a decline in net exports, a reduction in AE and a fall in GDP.


Net Export EffectContractionary fiscal policyResults in lower interest rates. This reduces the demand for the $A leading to its depreciation and an increase in net exports, an increase in AE and an rise in GDP.

The Net Export Effect, with a freely-floating exchange rate, reduces the overall impact of fiscal policy on economic activity.


Crowding out and the Net Export EffectCrowding out and the Net Export Effect

Interest Rates

Budget Outcom

eExchange Rate

Exports

Investment

Aggregate

Demand


Budget Deficits and Aggregate DemandBudget Deficits and Aggregate DemandA Budget Deficit shifts AD to the right.

This increases output and prices

The full impact of FP will depend on price elasticity of SRAS.

The more price elastic is AS, the greater will be the impact on Y with smaller rise in price level.


Price level

Real GDP

AD1AD2

AS

Q2Q1 Q2

P1

P2

P3


Deficits & Aggregate Supply

Supply-siders argue for tax cuts – lower taxes increases disposable income and encourages saving and investment.

But they claim alter incentives to work.

Evidence on work incentive effects is VERY weak.


Price level

Real GDP

AS1

AD2

Q1

AD1

P1

AS2

Q2

P2

P3 =

Q3


LagsProblems of timing

Recognition lagsAdministrative lagsImplementation lags

Political problemsOther economic goals: not just

stabilityExpansionary biasA political business cycle


SUMMING UPFP will be more effective in influencing

economic activity if:Investment is not very responsive to interest rate changes.International capital flows are not very responsive to domestic interest rates.SRAS is very price elastic.Shorter are the policy lags.Less political interference on policy stance.


Annually balanced budgetAnnually balanced budgetPro-cyclical: intensifies recession or inflation

Cyclically balanced budgetCyclically balanced budgetCounter-cyclical

Not annually balancedNot annually balancedProblem: upswings and downswings may not be of equal magnitude


Functional financeFunctional financePrimary purpose is to balance the economy, not the budget

The problems of continuing annual deficits (or surpluses) may be small compared to the alternative: recession and high unemployment (inflation)








Public DebtPublic DebtThe total accumulation of the Federal Government’s total deficits and surpluses over timeGeneral govt sector net debt as share of GDP went below zero in 2004-05.

Myths about public debt:Government is going bankruptGovernment can refinance existing debt – saw before that debt really an instrument of monetary policy.Can create more money

Shifting burdens, future generations will pay for it



Problems with Public DebtProblems with Public DebtEconomic implications External debt may be a problem Increased taxes may dampen incentives - but saw

before no necessary link between money, debt & taxes.

Income distributionGovernment bonds are generally held by those wealthier members of society Composition important: capital versus consumer goods


Problems with Public Debt Problems with Public Debt Some argue there is a crowding-out effect and impact on the stock of capital

Future generations inherit a smaller stock of capital goods due to the crowding-out effect, which increases interest rates and so reduces investment spending

But in an economy with unemployed resources a government deficit, irrespective of how it is financed, has potential to increase output of both consumption and capital goods for an economy.


Public Debt: Positive RolePublic Debt: Positive RoleSaw before with Paradox of Thrift that if an economy’s saving was not matched by investment (or other injection) that economy would contract.

So borrowing & debt, transfer saving to spenders and thereby play a positive function in maintaining a high level of output and employment.

As well, government debt in the form of bonds offers private sector a low risk interest bearing asset in which to hold their wealth. Important to the depth & confidence of financial markets.


Jackson & McIver, Chapter 8McTaggart et al. Ch 25Kniest, Lee & Burgess, Chapter 11.


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M ACROECONOMIC P OLICY IN THE A SIA -P ACIFIC GECO6400 Fiscal Policy