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)
Production function
Y = lamdaN
Y = output lamda = labour productivity N = employment in the whole economy
The labour market
- assumed to be imperfectly competitive ( never clears)
- represented by a wage setting-price setting unemployment model
1. wage setting - workers with market power - workers and firms agree on nominal wage specific to them
- unemployment is a measure of how much bargaining power workers have
Real wage
w = W/P
W = nominal wage
P = aggregate price level
Wage setting curve
represents supply Side
curve that gives the real wage necessary at each level of economy-wide employment and provides workers with incentives to work hard and well
Incomplete contracts
firms can’t observe workers effort thus have to pay workers a real wage higher than the reservation wage to encourage effort
the lower the unemployment rate, the higher the wage must be since worried about getting fired
Price setting
firms set the price of their own goods, P
under perfect competition, P=MC=W/MPL
thus W/P = MPL
- under imperfect competition, the firms choice of profit maximising price also determines the firms optimal markup (M) above the marginal costs of production
price setting markup equation
P = (1 + mew)x W/MPL
mew = 1/n-1
where n = elasticity of demand and MPL = marginal product of labour
Price-setting real wage
w = W/P
= MPL/1+mew = (1-mew)MPL
assume MPL and mew constant
thus price setting real wage=
lamda(1 - mew)
how output is distributed between firm-owners and workers
lamda = pi/P + W/P
where pi/P = Mlamda = real profit per worker
and W/P is real wage per worker
- thus, once firms set their prices, this determines the level of output and markup in the economy
- this pins down the real wage
- assumption of constant output per worker (lamda) and that firms require a fixed profit margin to find it profitable to employ workers, fives a flat price-setting curve
PS curve is the curve that gives the real wage paid when firms chose they profit-maximising price
Price and wage nominal stickiness
- although workers and firms care about real wages, in reality wages are set in nominal terms and they are sticky to some extent
- some prices are flexible others aren’t
- nominal stickiness helps central banks influence the economy
The labour market equiibrium
graph of employment against real wage
labour productivity line is above PS curve
- WS = PS
- firms offering least wage to ensure workers effort
- employment is the highest it can be given the wage
- those with jobs cant improve their situation by asking for higher pay or working less hard
- those who don’t have jobs would like to work, but cannot persuade firms to hire them by accepting a lower wage (labour discipline concerns)
What shifts the WS curve?
factors the affect labour supply
e.g labour unions, unemployment benefits
What shifts the PS curve?
- factors that affect competition, which determines markup
- changes in labour productivity, which determines real wage for a given markup
- equilibrium real wage and unemployment change due to shifts in the WS and PS curves
Linking AD and unemployment
put multiplier and labour market models together
- high unemployment in a recession means low aggregate demand and vice versa
- normal in labour market equilibrium
cyclical (demand-deficient) unemployment
an increase in unemployment above equilibrium unemployment causes by a fall in AD associated with the business cycle
Cyclical employment
- the additional employment that results in unemployment falling below its equilibrium
- fluctuations in AD around the labour market equilibrium cause cyclical Unemployment
- excess demand above labour market equilibrium implies unemployment is below equilibrium level
