Fiscal stabilisation, Government finances and Unemployment Flashcards
Stabilising economic fluctuations
- size of government - government spending is stable
- automatic stabilisers
- Discretionary fiscal policy
Automatic stabilisers
- progressive taxation
- transfers: if they’re inversely proportional to output. e.g unemployment benefits helps households smooth consumption (failure of private market because of correlated risk, hidden actions, hidden attributes
- automatic stabilisers automatically offset an expansion contraction of the economy ( e.g tax revenues in the UL due to pandemic have significantly fallen)
- by definition automatic stabilisers are temporary
Discretionary Fiscal Policy
can be expansionary (fiscal stimulus) or contractionary (spending cuts)
Changes in tax rates
higher tax rate lowers the multiplier so shocks to demand have a smaller effect on output
Fiscal stimulus
gov can counteract the fall in AD from the private sector through fiscal stimulus:
- cutting taxes to encourage private sector to spend more
- increasing gov spending which directly increases aggregate demand
(the rise in G operates via the multiplier, the increase in Y will typically are greater than the increase in G)
- the gov can also decide to implement austerity measures as a discretionary policy (UK gov in 2010)
if a gov tries to improve its budgetary position in a recession by reducing expenditure, this austerity policy can reinforce a recession by further reducing aggregate demand
Was Obama’s economic stimulus package of 2009 a success?
estimated impact on GDP of a permanent increase in purchases of 1% of GDP
estimated output effects of governments purchases led to crowding out of consumption and investment (declined)
size of fiscal multiplier
change in output/change in gov spending
= 1/(1-C1(1-t)+m)
why is it difficult to measure size of the multiplier?
- Reverse causation - gov spending reacts to and affects outputs, so different episodes may not be comparable
- Rate of capacity utilisation (phase of business cycle)
- with fully employed resources, an increase in G would crowd out private spending
- Expectations of the private sector - the multiplier could be negative if rising fiscal deficit erodes consumer confidence
A rough rule for the gov multiplier
- normally between 0.8-1.5
- in a recession between 0.9-1.7
- larger in closed economies than open economies
- negative in high-debt countries
largely dependent on context
Financing a fiscal stimulus
done through borrowing or taxes
government budget constraint
Gt + i(Bt-1) = Tt + deltaBt + delta Mt
t = time period Bt-1 = outstanding stock of gov bonds at beginning of period t
nominal interest rate = i
T = tax revenues measured net of transfers
delta B = Bt - Bt-1 = the amount of new bonds issued in the current period
delta M = change of stock money issued by the central bank (assume = 0 as no printing money as source of cash)
change in new bonds
delta B = Gt - T + I(Bt-1)
where Gt - T is the primary deficit and the right hang side is the budget deficit
shows that the change in debt is equal to the sum of the extent to which current spending exceeds tax revenues and interest payments on outstanding stock of debt
fiscal stimulus will result in
a primary deficit where G-T>0 if D=0
or a higher primary deficit if initially G not = T
therefore gov must borrow more to cover additional gas between spending and revenue by issuing more bonds
thus gov debt increases
Government debt dynamics
the UK’s gov debt is higher than the country’s GDP. This has to be reversed
problem with high gov debt-GDP ratio
gov spending can be either the result of active stabilisation policy or ‘routine’ expenditure
but the level of gov debt matters too
- a large stock of gov debt-to-GDP may increase costs of borrowing for the gov. as default is seen to be more likely (default risk)
- can lead to a sovereign debt crisis:
a situation in which gov bonds come to be considered risky e.g Eurozone 2010-12
- to avoid the likelihood of this, gov debt-to-GDP ratio has to be reversed after a recession
e. g Argentina had 9th default on debt in 2020, UK paid 3.5% on its WWI bond instead of 5% - can also crowd out the private sector
What determines the path of gov debt over time?
- there’s no point at which gov has to pay off all of its stock of debt
- it can roll over instead by issuing new bonds
- an ever-increasing debt ration is unsustainable but there’s no rule of how much exactly of debt is problematic
Gov debt dynamics equation
change in existing gov debt-to-GDP ratio (delta b)
= d + (r-gammay)b
b = existing gov-debt-to-GDP ratio
d = primary deficit ratio
r = real interest rate (r = i - pi(inflation))
gammay = the growth rate of real GDP
when real interest rate greater than the growth rate of real GDP and there’s no primary deficit
with graph of delta b against b:
primary deficit is b (intercept), slope is r - gammay
- upward-sloping phase line: b rising unless there’s a primary surplus
- interest payments rising faster than GDP snd debt burden increases
- need primary surplus for delta b = 0 so unstable equilibrium exists
(ie intercept below axis)
when real interest rate less than growth rate of real GDP and there’s a primary deficit
- phase line has negative slope
- below x axis, ratio rises
- above, it falls. Constant at x=0
- growth of economy is sufficient to reduce impact of interest payments
- some primary deficit is consistent with delta b = 0
- there’s a stable equilibrium as economy moves back to x=0 after deviation
- the increase in b is dampened as y grows faster
whether a particular deficit is sustainable depends on
- the relationship between the interest rate and the economic growth rate
- if GDP is growing faster than gov. debt then the ratio
can fall
Govs indebtedness can also fall due to
- high inflation
- primary surplus
thus use monetary policy for stabilisation
fiscal policy should focus on sustainable financing gov spending and only should be used in deep crises
Limits of Fiscal policy
- Increased gov debt-to-GDP ratio so leads to higher default risk
- Happens with lags
- lengthy bureaucratic parliamentary debates
- could happen when no longer needed
Linking aggregate demand and unemployment
- the supply side: Labour market model - focuses on how labour is employed to produce goods and services
- demand side: multiplier model - explains how the spending decisions generate demand for goods and services, these employment and output
Supply side
consists of workers and firms at the aggregate level
assume capital and technology is exogenous (the same and ignored)
