4.5.3 - Public sector finances

Question 1

What is a discretionary fiscal policy ?

Answer 1

A fiscal policy that is implemented at the discretion of policy makers

Question 2

What is an automatic stabiliser ?

Answer 2

A feature of the tax and transfer system that reduces economic activity during booms and stimulates activity during slumps

Question 3

Do automatic stabilisers involve intervention by the government ?

Answer 3

No they do not involve direct intervention by the government

Question 4

In a recession, why does the ability of automatic stabilisers to reduce falls in economic output depend on the level unemployment benefits are set at?

Answer 4

In a recession, unemployment rises which leads to a fall in consumption as newly unemployed workers have less disposable income.

As a result, there is a general fall in demand for goods and services.

Consequently, unemployment is likely to increase further as fewer workers are needed.

This leads to a further fall in consumption which can in turn lead to yet further job losses.

Question 5

In a boom, why does the ability of automatic stabilisers to prevent the overheating of an economy depend on the level of income tax rates?

Answer 5

In a boom, wage growth is likely to be high as firms are forced to bid up wages due to low unemployment.

Due to the high wage growth, consumption is likely to increase. Therefore, more goods and services are demanded which means that firms are likely to struggle to find workers without raising wages.

Higher wages will boost consumption further raising AD.

This is likely to lead to inflation as booming economies have limited spare capacity.

Question 6

What do automatic stabilisers do ?

Answer 6

1. stimulate economic activity during a recession
2. reduce economic activity during a boom

Question 7

What do automatic stabilisers do ?

Answer 7

1. stimulate economic activity during a recession
2. reduce economic activity during a boom

Question 8

Why are automatic stabilisers said to be automatic ?

Answer 8

These ‘stabilisers’ are automatic because they occur without intervention

Question 9

What is the budget deficit ?

Answer 9

When government spending is greater than government revenue in a particular year. (GS>GR(T))

Question 10

What is national debt ?

Answer 10

A government’s total outstanding debt

Effectively what the government still owes from the budget deficits accumulated over time.

Question 11

What is the Debt-to-GDP ratio

Answer 11

Total government debt as a ratio of GDP.

This is used to judge the likelihood of government debt being repaid

Question 12

What is the relation between the debt to GDP ratio and the likeliness the debt gets paid back ?

Answer 12

In general, the larger the ratio the less likely repayment becomes.

Question 13

What is the Cyclical budget deficit ?

Answer 13

The part of a budget deficit that occurs due to automatic stabilisers.

Question 14

What effect do automatic stabilisers have on the cyclical budget deficit ?

Answer 14

From recovery to the peak of a business cycle, automatic stabilisers cause the cyclical budget deficit to fall.

From a peak to the trough of a business cycle, automatic stabilisers cause the cyclical budget deficit to rise.

Question 15

What is the structural budget deficit ?

Answer 15

The part of a budget deficit that occurs due to discretionary fiscal policy rather than automatic stabilisers e.g. changes to income tax rates.

Question 16

Which automatic stabilisers are designed to prevent an economy from overheating ?

Answer 16

Progressive income tax

Unemployment benefits

Question 17

How does a progressive income tax prevent the economy from overheating ?

Answer 17

ny wage gains made are diminished by income taxes in general. However, progressive ones will have a bigger effect as some people will move up into higher tax bands

Question 18

How do unemployment benefits prevent an economy from overheating ?

Answer 18

Less people will receive these in a boom as unemployment falls → less government spending → AD growth dampened

Question 18

How do unemployment benefits prevent an economy from overheating ?

Answer 18

Less people will receive these in a boom as unemployment falls → less government spending → AD growth dampened

Question 19

Which automatic stabilisers aim to prevent recessions from deepening ?

Answer 19

Unemployment benefits

Question 20

How do unemployment benefits prevent recessions from deepening

Answer 20

Workers laid off in a recession are entitled to claim unemployment benefits.

This boosts their incomes thereby increasing consumption.

Claimants are likely to have less income than prior to being made unemployed so consumption is likely to fall.

However unemployment benefits, by boosting their incomes, limit decreases to AD that this would cause.

Question 21

Explain how automatic stabilisers act to prevent recessions from deepening

Answer 21

In a recession, rises in unemployment and falls in consumption and investment occur.

Therefore, aggregate demand is likely to decrease further.

If government spending, another component of AD rose, this would act to reduce the decrease in AD or potentially cause it to rise.

Since automatic stabilisers increase government spending they limit the fall in AD recessions cause thus preventing them from deepening.

Question 22

What are the factors influencing the size of the deficit ?

Answer 22

State of the economy

The age distribution of the population

Discretionary fiscal policy

Debt interest

Question 23

How does the state of the economy affect the size of the deficit ?

Answer 23

If economic growth is strong, it is likely that wages, employment, and profit will be rising in the economy.

Therefore, the government will be earning additional tax revenue e.g. greater receipts of income tax.

At the same time, lower unemployment will reduce spending on unemployment benefits.

Therefore, a budget deficit is likely to increase in these circumstances.

If a government has a budget surplus, it’s likely to get larger for the same reason.

Question 24

What is the dependency ratio ?

Answer 24

The (age) dependency ratio is the ratio of dependents (i.e. people younger than 16 or older than 65) to the working-age population.

Question 25

How does the age distribution of the population affect the size of the deficit ?

Answer 25

Countries with ageing populations, such as Italy and the UK, have high, and increasing, dependency ratios.

This implies that there will be lower income tax revenues and higher expenditure on state pensions and the health services.

Therefore, there would be a deterioration in a government’s budget position.

Question 26

How does discretionary fiscal policy affect the size of the deficit ?

Answer 26

Governments may implement discretionary fiscal policy for a variety of reasons

The 2008 financial crisis led many governments to use fiscal policy to try and bring their economies out of recession.

Politicians may use fiscal policy to appease their supporters or financial backers.

Question 27

How does debt interest affect the size of the deficit ?

Answer 27

The larger the national debt is the greater interest payments on the debt will be.

Another factor which affects debt interest is interest rates

Question 28

What is the relationship between the budget deficit and the size of the national debt ?

Answer 28

If a government has a budget deficit, the size of the national debt will get larger

Question 28

What is the relationship between the budget deficit and the size of the national debt ?

Answer 28

If a government has a budget deficit, the size of the national debt will get larger

If a government has a budget surplus, the size of the national debt will get smaller

Question 29

What is the impact on fiscal deficits and national debt on interest rates ?

Answer 29

When the government runs a budget deficit, it has to borrow the money.

As a result, the demand for borrowed money rises relative to supply.

This causes the price of money to rise i.e. interest rates rise.

Question 30

What is the impact on fiscal deficits and national debt on debt servicing ?

Answer 30

Ceteris paribus, the greater the size of a national debt the larger debt repayments will be. Therefore, servicing the debt will become harder.

If interest rates are rising, debt servicing will become harder because interest payments will rise. This would worsen a fiscal deficit and also add to the national debt.

However, if interest rates fell, interest payments on the national debt would fall.

Question 31

What is the impact on fiscal deficits and national debt intergenerational equity ?

Answer 31

Increasing the national debt through running budget deficits can be seen as unfair to future generations because they are the ones that ultimately pay for it through higher taxes or lower government spending.

This may or may not happen.

It all depends on how the budget deficit affects long-term economic growth.

If over the long term it causes GDP to rise, this will likely result in higher government revenue thereby increasing the governments ability to service its debt and also making the country more creditworthy (since debt-to-GDP would be lower).

If there is no impact on economic growth, the opposite will happen because the national debt will rise causing the debt-to-GDP ratio to also rise.

Question 32

What are the areas of government spending that are likely to boost long term economic growth ?

Answer 32

Infrastructure, education, health

Question 33

What are the areas of government spending that are likely to have a negligible or negative impact on economic growth ?

Answer 33

War, vanity projects e.g. palaces for the President, Brazilian World Cup Stadia

Question 34

What is the impact on fiscal deficits and national debt on the rate of inflation ?

Answer 34

When a government runs a budget deficit, they can either borrow the money or print the money. The government could borrow the money by issuing bonds. If this happens the government spends more, and the private sector spends less. Therefore, there is no overall effect on aggregate demand and inflation will remain the same.

However, if the government prints money to finance the deficit, aggregate demand will increase because the government spending component of aggregate demand will rise. More money chasing the same number of goods results in demand pull inflation.

Question 35

What is meant by the term credit worthiness?

Answer 35

It is a measure of how likely an individual, firm or government will repay, or default, on a debt.

A person with a high paying job is more creditworthy than someone with a low-paying job.

Other factors affect credit worthiness such as age and one’s history.

Question 36

What is a credit rating?

Answer 36

A credit rating is an assessment of the creditworthiness of the borrower such as a company or government.

Credit rating is run from AAA (triple A) to D.

Question 37

Who are the three main credit rating agencies?

Answer 37

S and P’s, Moody’s, and Fitch.

Question 38

If a credit rating agency downgrade the credit rating of a company or country, how is this likely to affect the interest rate that investors/service demand when purchasing the bonds issued by the company or country?

Answer 38

It is likely to raise it.

Question 39

What does a low debt to GDP ratio indicate ?

Answer 39

indicates an economy that produces and sells enough goods and services without incurring further debt.

Question 40

How is a country able to run a high debt to GDP ratio ?

Answer 40

if they have a long history of debt repayment means that credit rating agencies and investors tend to view them as more creditworthy than others

Question 41

How is the economy likely to perform if they have a high debt to GDP ratio ?

Answer 41

If a country has a high or increasing debt to GDP ratio, there is a greater chance of the country’s economy performing poorly in the future

This could trigger a debt crisis which would plunder the country into a recession

Question 42

What is the relation between debt to GDP ratio and FDI ?

Answer 42

A high debt-to-GDP ratio is likely to reduce FDI, or at least restrict its rise, because TNCs will view investment as more risky.