4.5.3 Public sector finances

Question 1

Automatic stabilisers

Answer 1

These are automatic fiscal changes as the economy moves through stages of the business/trade cycle.

They do not require active intervention from the government but happen automatically in the background

• For example, a fall in tax revenues during a recession or an increase in state welfare benefits paid out when unemployment is rising.

Question 2

Discretionary fiscal policy

Answer 2

A demand-side policy that uses government spending & taxation policy to influence aggregate demand (AD).

• This is normative/political and is purely based on what fiscal policy the government wants to do.

Question 3

Fiscal deficit

Answer 3

When the level of government spending is greater than the government tax revenue in any given year.

Question 4

The national debt

Answer 4

The accumulation of any previous deficits.

The deficit in one year adds to the national debt from previous years.

• Also known as the public sector net debt (PSND).

Question 5

Types of government budget deficits?

Answer 5

• Cyclical deficits
• Structural deficits

Question 6

Cyclical deficits

Answer 6

Cyclical deficits occur due to downturns in the business/trade cycle, usually as a result of a recession.

• Governments receive less tax revenue as profits and incomes fall – and government spending increases
• These deficits tend to self-correct as the economy starts to grow again.

Question 7

Structural deficits

Answer 7

Structural deficits is caused by excessive borrowing.

They are present even when an economy may be operating at the full employment level of output (‘a boom’).

• They could also be caused by a widespread tax avoidance culture, or poor governance
• • These deficits are difficult to correct.

Question 8

How are budget deficits financed?

Answer 8

Public Sector Net Borrowing (PSNB) - this allows the government to spend more than it recieves in revenue.

Question 9

How does the PSNB allow the government to borrow money?

Answer 9

In the UK, the government can borrow the money it needs from UK banks, which will create deposits that the government can spend.

It can also borrow money from the private sector by selling Treasury bills, which the government will pay off over a period of time (e.g. 3 months), or it can borrow money from foreign financial markets.

• Treasury bills are short term (3/6 months)
• Treasury bonds are long term (1/2/5/15 years)

Question 10

Problems with excessive borrowing

Answer 10

• Excessive borrowing could cause demand-pull inflation, partly due to the fact that government borrowing increases the money supply, so there’s more money in the economy than can be matched by output.
• As borrowing may cause inflation, it can also lead to a rise in interest rates to curb that inflation. Higher interest rates will discourage investment by firms and make a country’s currency rise in value, meaning that its exports are less price competitive.

Question 11

Problems with a large and long term national debt.

Answer 11

• If a country’s debt becomes very large then it may cause firms and foreign countries to stop lending money to that country’s government. This will constrain the country’s ability to grow in future.
• Future taxpayers will be left with large interest payments on debt to pay off. Debt repayments have an opportunity cost as future governments may have to cut spending to pay off a debt, which may harm economic growth.
• A large national debt suggests that there’s been excessive borrowing, which causes inflation and interest rates to rise. It also suggests that public sector spending is very large, which may ‘crowd out’ private sector spending.
• A country with large debt is less attractive to foreign direct investment (FDI), as foreign countries will be uncertain how the debtor nation’s economy will do in future and whether it will be a good bet for investment.

Question 12

How can cyclical budget deficits be corrected?

Answer 12

A cyclical budget deficit is caused by recessions and comes about due to a government’s automatic stabilisers (when government spending on benefits increases and tax revenue falls).

• This kind of deficit will be corrected when the economy recovers again — the deficit will be replaced by a surplus.

Question 13

How can a structual budget deficit be corrected?

Answer 13

A structural budget deficit, caused by excessive borrowing, is much harder to solve.

• To cure this problem, governments will have to raise taxes and reduce public spending so that they can pay off their debt (these are known as ‘austerity measures’). However, these actions could harm economic growth and cause other problems.

Question 14

Factors influencing the size of fiscal deficits

Answer 14

Question 15

What unexpected shocks might governments experience?

Answer 15

• Natural disasters
• Wars
• Pandemics
• Financial crashes

Question 16

Budget surpluses

Answer 16

A budget surplus is more desirable than a budget deficit – but isn’t always a good thing.

Lowering taxes or increasing government spending would correct a budget surplus.

Question 17

What are the issues with budget surpluses?

Answer 17

A budget surplus might suggest that taxes are too high or that governments aren’t spending enough on the economy. Both of these things could harm or constrain economic growth.

Question 18

What are the two factors influencing the size of national debt?

Answer 18

• Size of fiscal deficits
• Government policies

Question 19

How do government policies affect the size of national debt?

Answer 19

These directly impact tax revenue & government spending which can change the level of the fiscal deficit leading to a change in the national debt level.

E.g. Reducing corporation tax during a boom in the economy will reduce government revenue & possibly increase the deficit & national debt at a time when the deficit would naturally be decreasing due to the automatic stabilisers.

Question 20

How does the size of fiscal deficits affect the size of national debt?

Answer 20

As national debt is the accumulation of annual fiscal deficits, the size of the fiscal deficit each year will grow by the size of the deficit.

If the UK were to run a budget surplus in any year, this additional revenue could be used to pay back some of the debt - or it may be used to fund government spending or investment in the following year.