4.5.3 Public sector finances

Question 1

Define automatic stabilisers

Answer 1

automatic fiscal changes as the economy moves through stages of the business cycle – e.g. a fall in tax revenues from the circular flow during a recession or an increase in state welfare benefits when unemployment is rising.

Question 2

Define discretionary fiscal policy

Answer 2

Deliberate attempts to affect the level and growth of aggregate demand using changes in government spending, direct and indirect taxation and borrowing.

Question 3

Evaluate automatic stabilisers

Answer 3

Benefits may act as a disincentive to work and lead to higher unemployment whilst
high levels of tax can decrease the incentive to work hard.

Question 4

Describe a recession

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

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

Answer 5

Progressive income taxes – any 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.

Unemployment benefits – less people will receive these in a boom as unemployment falls  less government spending  AD growth dampened.

Question 6

Which automatic stabilisers aim to prevent recessions from deepening?

Answer 6

• Unemployment benefits – workers laid off in a recession are entitled to claim unemployment benefits.
• This boost 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 this would cause

Question 7

Define national debt

Answer 7

A government’s total outstanding debt - effectively what the government
still owes from the budget deficits accumulated over time.

Question 8

Define debt servicing

Answer 8

The repayment of interest and principle to external creditors

Question 9

Define structural budget deficit

Answer 9

The structural deficit is that part of the deficit which is not related to the state of the economy; occurs due to discretionary fiscal policy. This part of the fiscal deficit will not disappear when the economy recovers.

Question 10

Define cyclical budget deficit

Answer 10

The size of the deficit is influenced by the state of the economy and occurs due to automatic stabilisers: in a boom,
tax receipts are relatively high and spending on unemployment benefit is
low.

Question 11

Factors aftecting the size of a fiscal deficit

Answer 11

• state of the economy (trade cycle)
  + In the UK, the fiscal deficit peaked in 2010 at 10.1% of GDP.
• age distribution of the population
• discretionary fiscal policy
• political priorities
• debt interest

Question 12

How does state of the economy affect FD size

Answer 12

• If economic growth is strong, that wages, employment, and profit will be rising in the economy so the gov earns extra tax revenue e.g. greater receipts of income tax. - lower unemployment will also 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 13

How does age distribution of populaiton affect size of FD

Answer 13

• 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 14

Unforseen events affecting fiscal deficit

Answer 14

• Many unforeseen events occur each year which require government support
• e.g. The Russian war on Ukraine started in February 2022 & by June 2022 the UK Government had spent £2.8 bn. in providing assistance
  -(it is worth noting that much of this went to the UK military industry to pay for weapons which were donated to the Ukraine. This increased UK GDP

Question 15

interest rates affecting fiscal deficit size

Answer 15

• If interest rates on government debt
  increase, the amount the government pays in interest repayments increases and this
  is likely to increase the deficit.
• The impact of this will depend on how significant interest repayments are in the size of the deficit.
• Interest rates depend on market
  rates and the credit ratings of the government. 7% of all UK government spending is on interest repayments of loans.

Question 16

Factors influencing the size of national debt

Answer 16

● If the government is continuously running a deficit, then the national debt will
increase overtime. There is a consensus view that fiscal deficits over 3% will lead
to growing national debt as a proportion of GDP . It is only when the government
runs a budget surplus that the size of the national debt decreases.

● Ageing populations tend to contribute to a high national debt since the government
runs a structural deficit in order to fund their pensions and care and this leads to a
high national debt.

Question 17

The significance of the size of fiscal deficits and national debts

Answer 17

interest rates
debt servicing
intergenerational equity
rate of inflation
credit rating
FDI

Question 18

Effect of ND on interest rates =

Answer 18

• higher the demand for money the higher interest rates will be. 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.
  Note: sometimes interest rates do not rise.
  feature crowding out diagra (s= loanable funds supply), demand is ??? check dal

Question 19

effect of ND on debt servicing

Answer 19

• 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 20

effect of ND on intergenerational equity

Answer 20

• Increasing the national debt through running budget deficits can be seen as unfair to future generations because they pay for it through higher taxes or lower government spending.
• This may or may not happen. It all depends 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 services 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 21

how to distinguish between successful and unsuccessful gov spending

Answer 21

Areas of government spending that are likely to boost long-term economic growth:
infrastructure, education, health

Areas of government spending that are likely to have a negative or negligible impact on economic growth: war, vanity projects e.g. palaces for the President, Brazilian World Cup stadia

Question 22

Potential link between inflation and ND

Answer 22

• When gov 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 AD and inflation will remain the same. So, the G component of
  aggregate demand will rise, but the private sector components of aggregate demand will fall by an equal amount.

+ 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 gods results in demand pull inflation. Governments only tend to use this option when they are unable to borrow (so eval is it is rare bc risky)

Question 23

Why might a country may have to print money

Answer 23

• If investors believe the countries national debt is unsustainable, then countries will find it hard to borrow money.
• This is because they are viewed as
  uncreditworthy by investors. Therefore, such governments will have no alternative but to print money to finance a budget deficit.
  Examples: Venezuela 2017, Zimbabwe 2008 to 2009, Germany in the 1920s.

Question 24

Why is credit rating important in national debt?

Answer 24

• If a credit rating agency downgrade the credit rating of a company or country,the interest rate that investors/service demand when purchasing the bonds issued by the company or country will rise
  -

Question 25

Linking between national debt to GDP and credit rating

Answer 25

• If a country has a low debt to GDP ratio, this indicates an economy that produces and sells enough goods and services without incurring further debt
• Therefore, a country’s credit rating is likely to fall if there is a significant rise in debt to GDP.
• For some countries, a long history of debt repayment means that credit rating agencies and investors tend to view them as more creditworthy than others.
  (For example, the UK and the US have never defaulted on their government debt)
• such countries are able to
  run relatively high debt to GDP ratios without suffering from falls in credit ratings. This is highly beneficial because it keeps interest rates on their debt low which means they can maintain debt sustainability.

Question 26

effects of ND on FDI

Answer 26

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
- investors may deem the country too much of a credit risk to lend to.
- This could trigger a debt crisis which would plunger country into recession.
- Due to these potential dangers, a high debt-to-GDP ratio is likely to reduce FDI, or at least restrict its rise, because TNCs will view investment as more