Fiscal stabilisation, Government finances and Unemployment

Question 1

Stabilising economic fluctuations

Answer 1

1. size of government - government spending is stable
2. automatic stabilisers
3. Discretionary fiscal policy

Question 2

Automatic stabilisers

Answer 2

• 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

Question 3

Discretionary Fiscal Policy

Answer 3

can be expansionary (fiscal stimulus) or contractionary (spending cuts)

Question 4

Changes in tax rates

Answer 4

higher tax rate lowers the multiplier so shocks to demand have a smaller effect on output

Question 5

Fiscal stimulus

Answer 5

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

Question 6

Was Obama’s economic stimulus package of 2009 a success?

Answer 6

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)

Question 7

size of fiscal multiplier

Answer 7

change in output/change in gov spending

= 1/(1-C1(1-t)+m)

Question 8

why is it difficult to measure size of the multiplier?

Answer 8

• 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

Question 9

A rough rule for the gov multiplier

Answer 9

• 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

Question 10

Financing a fiscal stimulus

Answer 10

done through borrowing or taxes

Question 11

government budget constraint

Answer 11

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)

Question 12

change in new bonds

Answer 12

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

Question 13

fiscal stimulus will result in

Answer 13

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

Question 14

Government debt dynamics

Answer 14

the UK’s gov debt is higher than the country’s GDP. This has to be reversed

Question 15

problem with high gov debt-GDP ratio

Answer 15

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

Question 16

What determines the path of gov debt over time?

Answer 16

• 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

Question 17

Gov debt dynamics equation

Answer 17

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

Question 18

when real interest rate greater than the growth rate of real GDP and there’s no primary deficit

Answer 18

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)

Question 19

when real interest rate less than growth rate of real GDP and there’s a primary deficit

Answer 19

• 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

Question 20

whether a particular deficit is sustainable depends on

Answer 20

• the relationship between the interest rate and the economic growth rate
• if GDP is growing faster than gov. debt then the ratio
  can fall

Question 21

Govs indebtedness can also fall due to

Answer 21

• 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

Question 22

Limits of Fiscal policy

Answer 22

1. Increased gov debt-to-GDP ratio so leads to higher default risk
2. Happens with lags

• lengthy bureaucratic parliamentary debates
• could happen when no longer needed

Question 23

Linking aggregate demand and unemployment

Answer 23

1. the supply side: Labour market model - focuses on how labour is employed to produce goods and services
2. demand side: multiplier model - explains how the spending decisions generate demand for goods and services, these employment and output

Question 24

Supply side

Answer 24

consists of workers and firms at the aggregate level

assume capital and technology is exogenous (the same and ignored)

Question 25

Production function

Answer 25

Y = lamdaN

Y = output 
lamda = labour productivity 
N = employment in the whole economy

Question 26

The labour market

Answer 26

• 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

Question 27

Real wage

Answer 27

w = W/P

W = nominal wage

P = aggregate price level

Question 28

Wage setting curve

Answer 28

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

Question 29

Incomplete contracts

Answer 29

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

Question 30

Price setting

Answer 30

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

Question 31

price setting markup equation

Answer 31

P = (1 + mew)x W/MPL

mew = 1/n-1

where n = elasticity of demand and MPL = marginal product of labour

Question 32

Price-setting real wage

Answer 32

w = W/P

= MPL/1+mew = (1-mew)MPL

assume MPL and mew constant

thus price setting real wage=

lamda(1 - mew)

Question 33

how output is distributed between firm-owners and workers

Answer 33

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

Question 34

Price and wage nominal stickiness

Answer 34

• 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

Question 35

The labour market equiibrium

Answer 35

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)

Question 36

What shifts the WS curve?

Answer 36

factors the affect labour supply

e.g labour unions, unemployment benefits

Question 37

What shifts the PS curve?

Answer 37

• 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

Question 38

Linking AD and unemployment

Answer 38

put multiplier and labour market models together

• high unemployment in a recession means low aggregate demand and vice versa
• normal in labour market equilibrium

Question 39

cyclical (demand-deficient) unemployment

Answer 39

an increase in unemployment above equilibrium unemployment causes by a fall in AD associated with the business cycle

Question 40

Cyclical employment

Answer 40

• 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