Countercyclical Policy

Question 1

What are the Goals of Countercyclical Policy

Answer 1

• Counter negative aggregate demand shocks to prevent recessions
• Counter positive aggregate demand shocks to prevent inflation

Question 2

Types of Countercyclical Policy

Answer 2

Fiscal Policy:

• Changes in government spending (including transfers), and in taxes
• Run by the Treasury

Monetary Policy:

• Purchase and sales of financial assets, setting of statutory interest rates
• Run by the Central Bank

Question 3

Fiscal Policy Concepts

Answer 3

• Gov spending = G + Transfers (benefits) + Interest
• Gov revenues = (mostly) taxes
• Deficit = Spending - Revenues = Change in debt
• Surplus = Revenues - Spending = - Change in debt

Question 4

How does the Government Finance and Spend in different economic periods

Answer 4

• Stimulus/Expansion (G⬆️) by increasing spending or cutting tax
• Austerity/Contraction (G⬇️) by trimming spendings and raising tax
• Paradox of thrift -> during a recession, households want to save but the government needs to get them spending of GDP will fall even further

Question 5

Why do we need Fiscal stimulus

Answer 5

Stabilisation in bad times:

• Increase in G -> voters decline in C
• Lower Tax -> increase C
• Taxes do not effect gov spending because they can always borrow

Deficit: G > T -> Need to borrow to cover gap (i.e. bonds)
Surplus: G < T -> Accumulate reserves

Fiscal stimulus not always good because of crowing out. Household’s know that gov expenditure needs to be funded and so anticipate tax increases and thus cut back on C.

Also borrowing (selling bonds, lower bond prices) - higher interest rates, lowers private investments, takes away from private sector

Question 6

Dual Role of Fiscal Policy

Answer 6

1) Source of Demand Shocks
- Recent austerity programme in the UK

2) A tool to counter other demand shocks
- Increase deficit in recessions
- Fiscal stimulus politicise in 2007-2009

Question 7

The Fiscal Multiplier**

Answer 7

• Change in GDP due to a £1 change in the deficit
• 1/1-MPC = k, k then affects AD -> Y = k(C + I + G + NX)
  GDP* = GDP + k(GDP)
• But, as we are considering a change in GDP due to a £1 change in the deficit, if the multiplier is < 1, there is still an overall increase in output which is hopefully less than the increase in the deficit. Deficit more likely to increase > GDP if k > 1
• Generally thought to be greater than 0, less than 1, possibly greater than 1 in severe recessions
• Also sometimes used as a gov spending multiplier or tax cut multiplier
• If the gov spending multiplier is less than 1, then C+I+NX decreases when G increases due to crowding out (anticipating tax increases or a rise in interest rates via higher prices) (always a certain level of crowding out, amplified by an increase in spending)

Question 8

Crowding Out

Answer 8

• Anticipation of future taxes
• Increase in interest rates
• Diversion of productive capacity (for spending increases)
• Gov may hire people otherwise used by private sector

Question 9

Golden rule for fiscal policy

Answer 9

• Deficit in recession/surplus in boom
• Balance the budget on average
• But don’t run a balanced budget all the time???