20

2 The Global Macroeconomy (Subject) / Lecture 3 - Fiscal Policy (Lesson)

This lesson was created by Janaw55.

Learn lesson

This lesson is not released for learning.

back  |  next 1 / 1

• Development of Public Spending G Peace Times: Upward Trend  War Times: Steep upward slope of Public Spending The richer we become, the more we like to use money
• Reasons for Public Expenditure 1. Collective Provision of Goods & Services: Defence Law and order Education Health Roads 2. Redistribution of Income between individuals & across time Pensions Unemployment Benefits - insurance scheme Support for families
• Types of government spending (G) 1) Level of Government National Local/state 2) Category of spending: a) Goods & services Current expenditure on goods and services Capital spending b) Transfer payments: Social security transfers Subsidies and grants Debt interest (today: very low interest rates, the riskier the higher)
• Public Spending Differences among Countries There is a certain level required for national defence, Law & Order, Basic education, etc. Beyond that, level of spending is a matter for politial choice  Collective spending appears to be "luxury" good - as incomes rise, we tend to spend an increasing proportion of it collectively Public spending is (as % of GDP) 20% in Korea 55% in Sweden The Fiscal Problem of the 21st Century - Developed Countries, i.e. US: G expected to rise faster than GDP due to Social security Health expense -> price of medicine is increasing - % of increase in health expenditure > % increase in GDP Developing Countries: Tax revenue is key constraint (lower tax bases, more income from foreign direct investment)
• Is Big G Bad for Growth? Not necessarily! No simple correlation between Government size and economic growth or investment rate - at least among OECD countries It is what the government spends money on and how it delivers services that matter Stupid government spending is bad for growth (corruption) A big government can be stupid on a bigger scale
• Do higher Taxes produce higher Revenue? Yes, if Demand Effect > Supply Effect Demand Effect > Supply Effect: Skandinvia High taxes but people see it being used well Supply Effect > Demand Effect - Voodoo Economics Cutting taxes may increase Revenue  High Income Taxes discourage productive effort because People work less hard Spend their time trying to avoid tax Brightest people leave the country l
• The Laffer Curve Tax cuts above tmax increase Revenue. Tax increases abote tmax bring in less Revenue T = t * Y What is tmax ? Research shows that curve is actually skewed tmax is quite high (about 75%)
• Stabilization Policy Derive the equilibrium between desired demand and output. Desired Demand = C + I + G + X-M Let's consider G and X-M given as zero for simplicity.  What can C and I depend on? C=f(Y-T) with T given I = f(r) where r is the real interest rate r= i - Π and Πe is inflation expectation 45 degree line = if Desired Dmand = Output (Demand = Supply)  DD is a function of i and Y since C and I are DD Keynesian Cross = intersept with 45 Degree Line and DD If Government increases G --> DD = C(Y-T) + I(r) + (G+ΔG) + X-M Upward Shift  Output increases to match increase in demand, which creates excess demand Excess demand trigger adjustment on supply side through price or quantity (depending on the time to adjust, elasticity, etc.)  Eventually, the Keynesian Cross intertect will be higher 
• Government Spending Multiplier If G is increased, output increases again to meet induced demand Government spending multiplier = ΔY/ ΔG If prices are fixed, government can kick in and provide programme that will have a multiplier effect on outcome Purpose of Fiscal Policy = increase or decrease G or T Examples of multipliers Country:      (1 year after change, 2 years after change) Euro area:  1.1 - 1.6 Germany: 1.2 - 1.1 US:           1.9 - 2.2 UK:          0.8 - 0.5
• Fiscal Deficits Primary Deficit = Total revenue - Total expenditure of Government Indication of total borrowings needed by Government Financed through... Borrowing from Central Bank of country Raising money from capital markets by issuing treasury bills and bonds Total Fiscal Deficit = Primary Deficit + Net Interest Payments
• Advertisement
• 2 Reasons Fiscal Deficit Changes from Year to Year Automatic Stabilisers Tax Revenue contracts with economy Unemployment benefits rise in downturn Banks bail out Discretionary Policy Government may deliberately choose to cut taxes and increase expenditure in downturn
• Crowding Out - Reason Fiscal Multiplier might now work (1) Ricardian Equivalence: Government Expenditure crowds out consumption Consumers save in expectation of future tax increases  (2) Government Expenditure crowds out investment: Increased borrowing leads to higher borrowing costs and less investment Large deficits lead to lower bond prices, higher interest rates and so lower I Supply of Bonds Increases with Deficit, Demand for Bonds stays the same
• Ricardian Equivalence The way government finances its activities  does not effect Economy Government can either finance its expenditure through Current taxes or Issuing debt –> Bonds - but debt is just postponed taxes When governments cut taxes consumers are not better off They just face a delay in when they pay taxes Therefore in response to government borrowing consumers save more Possible for multiplier to be zero
• Sustainable Debt Debt is sustainable if Debt/GDP not changing (1) Ratio rises because of interest payments r x (Debt/GDP)(2) Ratio falls because of output growth g x (Debt/GDP)(3) Debt increases because of primary deficit Putting (1), (2) and (3) together: Change Debt/GDP = (r-g) Debt/GDP + Primary Deficit/GDP Debt sustainability (Change Debt/GDP = 0),implies: (r-g) Debt = Primary Surplus -> The government needs to run a primary surplus to cover the excess of interest payments over GDP growth r>g: government has to run a primary surplus in order to control the debt-GDP ratio r<g: government can run a deficit (of a certain size) without seeing debt/GDP ratio increase - Shifts in interest rates and growth rates have big impact on government debt dynamics - If r increases with Debt/GDP and higher r leads to lower g then countries can rapidly find their public finances deteriorating
• How to run responsible fiscal policy Need not balance budget all the time Deficit in bad times AND surplus in good times If g > r one can even run deficits on average and still keep the Debt/GPD ratio stable Political economy is key (incentives)
• What is the right level of government debt? present value of taxes equal present value of expenditure Holds for infinite no of periods Assume government lasts for two periods and that at the end the government debt must be zero e.g D(2) = 01. Debt at end of first period = G(1) – T(1). By end of second period this has accumulated to (1+r)(G(1)-T(1))3. In addition the government has issued a deficit G(2)-T(2)4. Therefore: D(2) = G(2)-T(2) + (1+r)(G(1)-T(1)) = G(2)-T(2) + (1+r)D(1) D(1) = (T(2)-G(2))/(1+r) Government debt equals discounted value of future (primary) surpluses Countries with large debt must run larger future surpluses (or they default)
• Summary - Fiscal Policy Government debt shows very large and very long term swings  AAA rating buys governments a lot of time to adjust their primary surpluses. Better to let debt take the strain than sharp tax volatility Government expenditure can be justified by market failure. Richer countries tend to spend more through their government and mainly on transfer payments Taxes: Taxes are used either to correct for market failures or to raise revenue. Efficient taxes avoid taxing elastic commodities
• Does it matter if a country runs a deficit? Country can run deficit if deficit creates an offsetting future surplus e.g investment where return exceeds cost, education which brings forth future revenue Country cannot run deficit if deficit is just government consumption: Country can get future surplus only if reduce future expenditure or raise future taxes
• Fiscal Deficit - 4 Statements TRUE Depending upon interest rates and growth governments can continually run a deficit without seeing debt increase Solvency requires that current debts are matched by future surpluses. Deficits can therefore be justified if they are for investment Deficits can have an expansionary effect on economy but multiplier is probably less than 1
• Politicians like Voodoo Economics Supply Side Effect < Demand Side Effect (1) Trump View (2) Regan tried it out in practice: For high income Earners, the Laffer Curve did Operate (low tax rates encouraged them to switch to pecuniary benefits which increases Revenue) Small Supply Side Effect - Tax cuts led to huge deficit 

back  |  next 1 / 1