Macroeconomic Theory
Chapter 5:
Fiscal Policy
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Roles of Fiscal policy
To provide automatic stabilizers to insulate the economy from
shocks to AD (tax and social security).
2. To stabilize output around eq. rate using discretionary fiscal
policy (another policy).
3. To plan the financing of g and to maintain a sustainable burden
of public debt.
1.
 The Automatic Stabilizers
 Tax and benefit system depend on the level of activity. They
reduce the size of the multiplier and dampen the impact of any
exogenous changes in private spending on output. As a
consequence budget deficit rises when activity falls and declines
when activity rise.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Calculating the cyclically adjusted budget deficit, the deficit that
would prevail given existing taxes and spending commitments if
the economy was operating at ye, this indicates whether fiscal
policy is expansionary or contractionary.
 Fiscal stance:
Primary B. deficit=cycl. Adj. B. deficit + impact of aut. stabilizers
=discret. fiscal impulse + impact of aut. stabilizers
g(yt) – t(yt) ≡
[g(ye) – t(ye)]
+
a(ye – yt)
discretionary fiscal. Impulse
automatic Stabilizers
 During recession a(ye – yt)>0, pushing up B. deficit and vice versa.
 At ye; a(ye – yt) = 0.
 A cycl. Adj. B deficit  expansionary fiscal stance
 A cycl. Adj. B surplus  contractionary fiscal stance
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 If the cycl. adj. surplus or deficit = 0  the actual deficit reflects
the automatic stabilizers and will disappear once the economy
returns to eq.
 When we have cycl. adj. deficit, the govt. has to recognize that
eventually it may have to take measures to reduce the increase in
debt when the economy returns to ye.
 Discretionary fiscal policy
 In the IS/LM g is normally assumed to be exogenous, t is either
exogenous or a function of income. So far we did not consider how
the increase in g is financed.
 First, assume that households and firms take the view that govt
bonds comprise part of their wealth.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Second, we investigate the claim that bonds are not wealth for
the personal sector “the Ricardian equivalence”. Far sighted
household realizes that any bonds issued to finance g have to be
repaid in higher t later.
 The government budget identity
 In nominal terms the govt budget identity in each period is:
G
Govt exp.
+
iB
Interest
≡
T
tax rev.
+
ΔB
new bonds
+
ΔH
new money
 The fiscal policy transmission mechanism
↑g → ↑ y → ↑ (M/p)D → ↑ r → ↓ I.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
See figure (6.1a)
 The IS shifts to RHS, the economy moves along LM (financial
crowding out). y expands but because the increase in g is financed
entirely by new bond issues, r rises. The full multiplier effect of
the rise in g does not occur: y is higher but its composition is
different (higher g and lower I). This crowding out does not occur
if interest rate is held constant (i.e., MS expands to meet
additional MD).
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6.1a
Higher r and y
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Tax finance and the balanced budget multiplier
 We know that if g increased, t will rise, but induced tax is
insufficient to close the gap between g and t. assuming a
proportional tax t = tyy. There will be a budget balance if:
Δg = Δt
= ty Δy
 Δy/Δg = 1/ty
 The multiplier effect of the change in g is 1/ty , but the expenditure
multiplier is:
Δy/Δg = 1/(sy + cyty)
Which is smaller than 1/ty. This implies that tax revenues at the new
eq y < g.
 The boost to y from higher g leads to a budget deficit, since the
rise in y generates saving plus taxation. Since there is a deficit, the
government is borrowing to implement spending plans.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 What is the effect on the economy of a fully tax-financed g? The

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




impact on output of a change in g:
Δy = Δg + cyΔg + cy(cyΔg) + …
The impact on output of a change in t:
Δy = -cyΔt - cy(cyΔt) - …
since Δg = Δt, it is clear that the net effect of the balanced budget
expenditure program is:
Δy = Δg = Δt
i.e., Δy/Δg = 1
(balanced budget multiplier)
The balanced budget multiplier is important for policy purposes.
The govt that is unable or unwilling to use debt or money
financing can still raise the level of activity by engaging in a
balanced budget expenditure program. The size of the multiplier
will be pulled down below one once the impact of higher y on MD
and r are introduced (fig. 5.1b)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Bond finance
 As shown above a rise in g will not induce sufficient extra t to
wipe out the deficit. There will be a continuing requirement to sell
bonds to cover the gap between g and t. the stock of bonds will
mount each year.
 The implications of this depend on whether government bonds are
considered a net wealth by private sector agents or not.
 If bonds are net wealth, their stock will influence both
consumption and MD. The govt should take into account these
changes when setting both monetary and fiscal policy.
 In addition, the new bonds will produce a portfolio effect in the
demand for money. At a given r higher wealth raises MD and
bonds in proportion so as to keep the portfolio balanced. The LM
will shift to the left (figure 6.1c).
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Are bonds net wealth? The Ricardian equivalence debate
 If bonds are not net wealth by households, there will be two
implications:
1.
2.
The consequences of wealth changes due to govt bonds disappear.
The expansionary impact of the spending program shrinks back to that of
a balanced budget.
 Households take into account that taxes in the future will have to
be raised to service the debt. This is known as the Ricardian
equivalence. This result depend on the following assumptions:
1.
2.
3.
The absence of liquidity constraints on households, they are able to borrow
against expected income at the current interest rate
Interest r and time horizon faced by the govt and households are the same
Households have heirs and incorporate their utility into their consumption
behavior, i.e., households behave as if they last forever.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Money finance fiscal expansion
 The govt sells bonds to the CB to be used for spending. This is
ruled out by the constitution of the CB in some countries. In
money finance fiscal expansion, r will decline and y will increase
in the short run.
 The short run effect of this type of finance is illustrated in in fig.
6.1d.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 5.1d
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Deficits and debt
 What determines the path of debt overtime? And if it is rising will
continue rising indefinitely?
 We take the analysis in two steps; first we exclude the possibility
that the govt can borrow from the CB. The budget identity is:
G
+
iB ≡ T + ΔB
Govt exp.
Interest
tax rev.
new bonds
 The actual deficit ≡ G + iB - T
 The primary deficit ≡ G - T
 By rearranging the budget identity the actual deficit is equal to
the change in the stock of govt debt:
 ΔB ≡ (G – T) + iB
 Change in debt ≡ primary deficit + interest on outstanding debt
 Change in debt ≡ actual deficit
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The debt ratio is
 Debt ratio ≡ b = B/py
 The actual deficit to GDP
 Actual deficit/GDP = ΔB/py ≡ (G-T)/py + iB/py
≡ d + ib
 The ratio of the primary deficit to national income is:
 Primary deficit/GDP = d ≡ (G-T)/py
B ≡ bpy
 Use approximation that
ΔB ≈ pyΔb + byΔp + bpΔy
ΔB/py = (bΔpy)/py + (bΔyp)/py + (Δbpy)/py
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
= bπ + bγy + Δb
 Where π is inflation and γy is the growth rate of output. Using
r=i-π, we get the following change in the debt to GDP ratio:
Δb = d + (i-π-γy)b
= d + (r-γy)b
To interpret the equation let us consider tow cases:
 Case 1: r > γy. Total debt will be rising unless d is negative, i.e.,
unless there is a primary B surplus. Interest payments are rising
faster than is GDP. Servicing the debt is pushing up the debt
burden. the only way to offset that b does not rise is for the govt
to run a primary budget surplus
 Case 2: r < γy. The growth of the economy is sufficient to reduce
the impact of interest payments on the debt burden. If the govt
were to run a B surplus, it would eventually end up with negative
public debt.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Fig. 6.2b shows an economy with the same r and γy as in fig 6.2a
but with a primary surplus (the intercept is below the horizontal
axis).
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig. 6.2Case 1. r > γy.
Phase line
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 6.3 Case 2. r < γy.
deficit
Positive b
surplus
Negative b
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Fig 6.4
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The case of high and rising govt debt.
 In advanced countries it is typically the case that the real interest

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

rate on govt bonds is risk free, this means it is well below real rate
of return on fixed investment.
When r > γy a substantial primary surplus is required to stop b
from rising and reduce the debt burden. This is likely to create
problems for a number of reasons:
Increasing B. surplus either requires painful cuts in g or increase
t, because of its supply side effects, t will raise eq. unemployment.
A high level of debt may raise the concern that the govt may
default, the govt will face a higher r which will worsen the debt
burden and dampening investments.
To continue to finance its expenditure the govt may resort to
monetizing the debt.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Now let us highlight the potential feedback from b to r. assume
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that r < γy, the govt intertemporal budget identity can also be
interpreted as its solvency constraint. Assume that there is a b > 0,
for the debt to stop increasing Δb ≤ 0
Since Δb = d + (r- γy).b
This implies that for Δb ≤ 0
b ≤ -d/r-γy
i.e. debt/GDP ≤ (primary surplus/GDP)/(r-γy)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Costs of fiscal consolidation: Cold turkey versus gradualism
 The fiscal consolidation refers to the implementation of fiscal
policy so as to achieve as sustainable debt ratio. The trade off
between a cold turkey and a gradualist strategy of fiscal policy is
illustrated in fig. 6.5.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
At A: unsustainable debt
The govt wishes to reduce b to D: lower surplus
Fiscal policy can’t be relaxed immediately, and debt
Will grow forever,
D Long run sustainable position
The govt may tighten fiscal policy by raising s to S1
The economy would move from A to B and to C
Fiscal stance can be relaxed to S2, the cost is sharp
Tightening of policy
An alternative is a more gradual policy to get the economy at s’, then
Adjust the surplus to S’’ and so on till D is reached
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Can fiscal consolidation be expansionary
 Why fiscal consolidation may stimulate AD? If the economy is
already at fiscal stress (unsustainable fiscal position), because of
the risk premium, r will be higher. Households may have lowered
their estimation of their wealth. A fiscal consolidation may be
viewed as credible, and boast investment and consumption by
reducing risk premium and restoring optimism about wealth.
 Less dramatic argument if the govt announces a fiscal
consolidation plan based on cutting govt consumption rather than
investment or raising taxation, the public may believe that this
signals a commitment to fiscal reform. This may lift wealth
expectations, the public is able to borrow against expected
income, consumption would rise, and to the extent that
consolidation is believed an enduring one, expected r will be lower
and investment will rise.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Consolidation via cutting govt consumption is costly in political
terms rather than govt investment or raising taxes, consolidation
here may be more effectively signal its seriousness about fiscal
reform and have a stronger effect on private sector expectations.
 The insights from the imperfect competition macro model
highlights the need to take account when analyzing the impact of
fiscal consolidation program of:


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The supply side impact of the consolidation policy
The stance of monetary policy
Other supply side policies.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Monetizing the debt: seignorage and hyperinflation
 If the govt cannot borrow (high risk of default) or raise tax, it may
use monetary financing. We know the govt B constraint:
G
+
iB ≡ T + ΔB + ΔH
Govt exp.
Interest
tax rev.
new bonds
new money
 Where M= ĸ . H (ĸ=kappa is the multiplier). Now
 ΔB ≡ (G-T) + iB – ΔH
 Dividing by nominal GDP
 ΔB/py ≡ (G-T)/py + iB/py – ΔH/py





= d + ib - ΔH/H . H/py
= d + ib – γHh
Where γH the growth rate of H and h is H/py.
Δb = d + (i-π-γy)b - γHh
= d + (r-γy)b - γHh
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 i.e., the growth of the debt to GDP ratio will be reduced to the
extent that the deficit is being financed by new money creation.
 In the medium run MS growth is equal to inflation rate. Assuming
ĸ is constant, γM = γH = π.

Higher π will reduce the growth of the debt ratio-assuming h remains
constant. This has led to the use of the term inflation tax to refer to this
method of finance.
 Seignorage revenue is therefore:
 S = ΔH/p

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


= ΔH/H . H/p
= γH . H/p
In the medium run eq.
As a proportion of y
S/y = γH . h
Macroeconomic Theory
S = π . H/p
Prof. M. El-Sakka
CBA. Kuwait University
 The definition of seignorage suggests that the govt can fiance
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more of its expenditure through seignorage by raising inflation.
There is a limit to the extent that seignorage can be used as a
source of revenue. As inflation goes up the public becomes less
willing to hold money. Recall money market eq.
(M/p)S = (M/p)D
= L(i,y)
= L(r + π, y)
When π is high, the demand for money balances is low. If we
substitute the demand for money into the seignorage expression
S = π . H/p
= π . (M/p) . 1/ĸ
Whilst higher money growth pushes up seignorage, via the first
term (π), it pushes it down via the second term (M/p) . 1/ĸ
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 To use the tax analogy, pushing up the rat of taxation (π), has the
effect of reducing the tax base.
 Empirical research suggests that the second effect begins to
outweigh the first when inflation rate go higher than about 200%
p.a. this suggests that the maximum amount of revenue the govt
could raise this way would be about 10% of GDP.
 Governments curtail their use of seignorage because the costs of
higher inflation outweigh the benefits.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Fiscal policy rules
 A prudent fiscal policy is one in which the government is solvent
based on long run or permanent values of the relevant variables.
On this prudent fiscal policy rule (PFPR), it is possible to compare
it already with existing fiscal policy rules.
 From budget constraint to PFPR
Δb = d + (r-γy)b
6.16
= (g/y – t/y) + (r-γy)b
6.17
Δb = d + (i-π-γy)b
6.18
= (d + ib) – (π + γy)b
6.19
 The debt ratio is raised by the actual deficit (d + ib) and reduced
by the growth of GDP ((π + γy)b). It is also useful to write (6.19) in
terms of the actual deficit:
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Deficit/GDP=(d+ib)=Δb+(π + γy)b
6.20
 Deriving a rule for prudent fiscal policy begins from the condition
Δb≤0 for the debt ratio not to increase. This implies:
b ≤((t/y)p – (g/y)p)/(rp – γyp)
6.21
 Where p (permanent value). Assume that there is a given public
expenditure program that entails a long run ratio of g, (g/y)p, how
should this best financed? For the debt ratio not to increase,
rewriting 6.21 implies
(t/y)p ≥ (g/y)p + (rp – γyp).b
 A prudent fiscal rule is to set the share of tax in GDP at a constant
level required to satisfy the constraint:
(t/y)par = (t/y)p ≥ (g/y)p + (rp – γyp).b
prudent fiscal policy rule
 Substituting the PFPR into 6.17 implies the debt ratio moves as
follows
Δb≤ (g/y – (g/y)p) + (r – rp) – (γy - γyp).b
6.22
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The rule implies that if govt expenditure is temporarily above its
permanent level, borrowing should finance this-this entails a rise
in the debt ratio and is consistent with the rule. This would be the
case if there is a recession, or if major infrastructure investment is
planned.
 Equally the rule says that an expected rise in permanent govt
spending, for example, as a consequence of long run govt pension
obligations must be funded by a rise in taxation.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 How the PFPR deals with stabilization and structural problems
 Stabilization
 What does the PFPR imply about the balance between automatic
stabilizers and discretionary fiscal policy?
 The rule implies that whilst g share can be expected to rise above
long run level in cyclical downturns, this must be reversed in
upswings. Averaged over the cycle, there is no case for a
divergence between g/y and (g/y)p.
 The implication is that the prudent cyclically adjusted primary
budget deficit will depend on pre-existing debt ratio and on the
difference between r and γy. e.g., if the debt ratio is 0.6, and rp–γy
is 2.4% then the PFPR says that the cyclically adjusted primary
budget surplus should be at least 1.4% (0.6 x 0.024).
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 In introducing the concepts of actual and cyclically adjusted
budget balance. Decompose the observed budget deficit into the
part that is due to the operation of automatic stabilizers (a(ye-yt))
and the deficit that would characterize the economy at ye.
 If the automatic stabilizers are fixed, the center attention is on the
use of discretionary policy to stabilize y in the face of the shocks.
But another way of thinking about eq. 6.1:
g(yt)-t(yt) ≡ [g(ye)-t(ye)] + a(ye-yt)
 Is as a rule for fiscal policy. If the govt aim is to stabilize y at ye
with the budget in balance, it should choose “a” to achieve this
objective.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Structural fiscal policy
 Unlike monetary policy, fiscal policy relates not only to the cycle
but to govt expenditure programs with effects lasting for decades.


The govt may wish to introduce structural policies whose effects may not be
permanent, despite extending over many B cycles.
Other policies may be of indefinite duration (permanent).
 Of the first type renewing infrastructure ((g/y)>(g/y)p). Of the
second type is commitment to pay pensions to aging population,
((g/y)p>(g/y)) and the tax share should be raised to its higher long
term level.
 Why a constant share of taxation
 Why establish the PFPR rule in terms of a constant tax share?
With diminishing marginal utility the optimal way for the govt is
to smooth its tax revenue collection over time and borrows and
saves in response to unforeseen fluctuations in expenditure
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Comparing existing fiscal rules with the PFPR
 It is helpful to express the govt B constraint in the form:
Deficit/GDP = (d+ib) = Δb + (π + γy)b
 We can then rewrite PFPR by substituting this into 6.22 and
rearranging:
Deficit/GDP ≤ ((g/y)-g(g/y)p) + [(r-rp)-(γy - γyp)] b + (π + γy).b
 This form of PFPR brings out the fact that higher deficit ratio is
compatible with solvency if the growth rate of nominal GDP
(π+γy) is higher.
 The stability and growth pact
 The Stability and Growth Pact of the European Union contains
two rules:
 1. d must be less than 3%
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 2. the cyclically adjusted deficit ratio should be in balance or in
surplus
 i.e.;
Deficit/GDP ≤ 0.03
Cyclically adjusted deficit/GDP ≤ 0
(rule 1)
(rule 2)
 The first rule places a rigid limit on d and hence the scope for
fiscal stabilization.
 The PFPR indicates that there is no economic reason for the
deficit limit to be a fixed number.
 The second rule places a rigid limit on the extent to which fiscal
policy can be used for structural purposes.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Golden Rule (e.g. UK)
 Cyclically adjusted deficit ratio must be no larger than is required
to finance govt investment spending (as a share of GDP)
~
 Cyclically adjusted deficit/GPD ≤ gI/y
 Where (gI) ~ is the cyclically adjusted govt investment spending.
 This rule is less restrictive than the Stability and Growth Pact for
two reasons: first it does not interfere with the operation of the
automatic stabilizers and second it allows more scope for
structural fiscal policy.

Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University