IF1203 Macroeconomics
BSc Banking and International Finance
BSc Accounting and Finance
BSc IFRM
BSc Finance
Live session week 4: Fiscal policy
a.chrystal@city.ac.uk
Main points of the lecture
• Fiscal policy is about shifting AD to stabilize real GDP….by changing G or
taxes…..but governments have many other objectives!
• Active fiscal fine tuning was the key policy to come out of the Keynesian
revolution and was used actively up to the 1970s.
• However, fiscal fine-tuning went out of fashion and fiscal policy became
more about planning the size of G and then financing that over the
business cycle.
• The 2008/9 crisis changed all that, at least in the short-term, as fiscal
stimulus packages were used to help offset the recession. (Gross tuning
instead of fine tuning)
• However, big deficits then became the problem and many governments
embarked on spending cuts and/or tax rises.
• These austerity policies are still a source of controversy.
• The Covid crisis and the energy crisis have been associated with large
government budget deficits and growing public debt.
• BUT energy prices are falling, and fiscal deficits are shrinking, so what will
policy makers do next?
SRAS
SRAS
C
A
B
B
A
C
AD
Output
Gap
Output
Gap
Y0
[i]. A Recessionary Output Gap
Y*
Real GDP
Y*
Y1
[ii]. An Inflationary Output Gap
Demand shocks
AD
Real GDP
SRAS
SRAS
C
C
B
B
A
A
AD
AD
Y0
[i]. A Recessionary Output Gap
Y*
Real GDP
Y*
Y1
[ii]. An Inflationary Output Gap
Supply shocks
Real GDP
Fiscal policy in reality
• Monetary and fiscal policies can both be used in principle to shift AD.
We look at monetary policy in week 6.
• BUT governments had generally abandoned use of taxes and
spending for fine tuning.
Labour Prime Minister Jim Callaghan said in 1976:
“We used to think that you could spend your way out of recession and increase employment by
cutting taxes and boosting Government spending. I tell you in all candour that that option no
longer exists, and that insofar as it ever did exist, it only worked on each occasion since the
war by injecting a bigger dose of inflation into the economy, followed by a higher level of
unemployment as the next step. Higher inflation followed by higher unemployment.”
• So, fiscal fine tuning was abandoned and interest rate policy became
the main short-term adjustment tool. Though fiscal policy was used
to offset major crises (eg the GFC, the Covid pandemic and the
energy crisis: Gross tuning.)
Why did we give up on fine tuning?
• Expenditure changes are very hard to agree once plans have
been announced and commitments may have been made several
years ahead.
• Tax rates can be changed but not much more than once a year
and governments tend to make longer term commitments in their
election manifesto….eg “we will not raise income tax in this
parliament”
• Fiscal policy is subject to several important lags:
• The information lag: we do not know where we are let alone
where we have been recently.
• The decision lag: it takes time to interpret the data on the state
of the economy and then to decide what to do about it.
• The execution lag: once we have decided what to do it takes
time to do it.
• The implementation lag: once a policy has changed it takes a
long time for the full effect to be felt.
Why fine tuning with fiscal policy might not
work
• Time lags are variable and uncertain.
• The economy is subject to changing and uncertain
shocks.
• With all the time lags involved, the impact of the
policy change may be destabilising rather than
stabilising.
• By the time the impact is felt the world may have
changed.
• The evidence for UK in 1950s and 1960s is that,
while the Government was trying to stabilise, the
impact of its action was destabilising.
Ideal policy timing
GDP
Growth
Rate
Time
Policy works with a lag so may add to instability
GDP
Growth
Rate
Time
1900-01
1902-03
1904-05
1906-07
1908-09
1910-11
1912-13
1914-15
1916-17
1918-19
1920-21
1922-23
1924-25
1926-27
1928-29
1930-31
1932-33
1934-35
1936-37
1938-39
1940-41
1942-43
1944-45
1946-47
1948-49
1950-51
1952-53
1954-55
1956-57
1958-59
1960-61
1962-63
1964-65
1966-67
1968-69
1970-71
1972-73
1974-75
1976-77
1978-79
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
1996-97
1998-99
2000-01
2002-03
2004-05
2006-07
2008-09
2010-11
2012-13
2014-15
2016-17
2018-19
2020-21
2022-23
2024-25
2026-27
Total Spending and Total Revenue (as percent of GDP) 1900 to
2027
70
60
50
40
30
20
10
0
revenue
spending
Total government spending and receipts (% of GDP) 1948 to 2027
60
Public sector current receipts
55
Total managed expenditure
50
45
40
35
30
25
1948
1952
1956-57
1960-61
1964-65
1968-69
1972-73
1976-77
1980-81
1984-85
1988-89
1992-93
1996-97
2000-01
2004-05
2008-09
2012-13
2016-17
2020-21
2024-25
1900-01
1902-03
1904-05
1906-07
1908-09
1910-11
1912-13
1914-15
1916-17
1918-19
1920-21
1922-23
1924-25
1926-27
1928-29
1930-31
1932-33
1934-35
1936-37
1938-39
1940-41
1942-43
1944-45
1946-47
1948-49
1950-51
1952-53
1954-55
1956-57
1958-59
1960-61
1962-63
1964-65
1966-67
1968-69
1970-71
1972-73
1974-75
1976-77
1978-79
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
1996-97
1998-99
2000-01
2002-03
2004-05
2006-07
2008-09
2010-11
2012-13
2014-15
2016-17
2018-19
2020-21
2022-23
2024-25
2026-27
UK Public Sector Net Borrowing (percent of GDP) 1900 to 2027
30
25
20
15
10
5
0
-5
-10
Fiscal policy effects take time so policy makers need to
forecast where the economy would be if policy did not
change
■There are time lags involved in both in both fiscal and monetary policy having an
impact on output and inflation.
■So policy makers have to form some kind of forecast to help them decide what
needs to be done.
■Sometimes this is easy, like when a lockdown was imposed, but at other times it
is hard to get the forecast right.
■Forecasts have tended to assume in the medium term that the economy will
return to the previous trend.
■This has led to over-optimistic growth and productivity forecasts (especially)
since the GFC.
UK GDP growth: successive forecasts
Fiscal: £ billion (unless otherwise stated)
Economy: Percentage change on previous year (unless otherwise stated)
10
5
0
-5
-10
-15
2008
2009
2010
2011
2012
June 2010
2013
2014
2015
2016
2017
Successive forecasts
2018
2019
2020
2021
November 2022
2022
2023
2024
Outturn data
2025 2026-272027-28
Fiscal: £ billion (unless otherwise stated)
Economy: Percentage change on previous year (unless otherwise stated)
Productivity (output per hour) growth rate:
Forecast and outturn.
3
2,5
2
1,5
1
0,5
0
-0,5
-1
-1,5
-2
-2,5
2008
2009
2010
2011
2012
June 2010
2013
2014
2015
2016
2017
Successive forecasts
2018
2019
2020
2021
November 2022
2022
2023
2024
Outturn data
2025
2026
2027
Fiscal: £ billion (unless otherwise stated)
Economy: Percentage change on previous year (unless otherwise stated)
Business Investment (latest Nov 2022)
20
15
10
5
0
-5
-10
-15
-20
-25
2008
2009
2010
2011
2012
June 2010
2013
2014
2015
2016
2017
Successive forecasts
2018
2019
2020
2021
November 2022
2022
2023
2024
2025
Outturn data
2026
2027
UK current budget deficit, % of GDP
Fiscal: £ billion (unless otherwise stated)
Economy: Percentage change on previous year (unless otherwise stated)
16
14
12
10
8
6
4
2
0
-2
-4
2008-09
2010-11
2012-13
June 2010
2014-15
2016-17
Successive forecasts
2018-19
2020-21
November 2022
2022-23
2024-25
Outturn data
2026-27
Some useful terminology
■The cyclically adjusted budget deficit is what the deficit would be if the
economy was at potential GDP (or full employment)
■It is also called the structural budget deficit.
■The primary budget deficit is the difference between spending and receipts
when the debt interest is excluded from the spending.
Fiscal: £ billion (unless otherwise stated)
Economy: Percentage change on previous year (unless otherwise stated)
Cyclically adjusted current budget balance (percent of GDP)
16
14
12
10
8
6
4
2
0
-2
-4
2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22 2023-24 2023-24 2024-25 2025-26 2026-27 2027-28
June 2010
Successive forecasts
November 2022
Outturn data
So what is the problem with public debt?
■If the public debt gets “too large” then it may become hard to sustain.
■The interest on the debt may put a strain on the rest of the public
finances….BUT for most governments interest rates have been
low……until very recently.
■The outcome may depend on who holds the debt.
■Domestically held debt may be easier to manage than debt held
overseas.
■Net debt is what matters not gross debt, as many governments also
have large asset stocks.
■THUS how much debt is too much varies from place to place and from
time to time.
■NOTE: In the UK the “National Debt” is the debt of the central
government (mainly to domestic investment funds) and not the debt of
the country to the rest of the world.
Fiscal: £ billion (unless otherwise stated)
Economy: Percentage change on previous year (unless otherwise stated)
UK public sector net debt, % of GDP
Successive forecasts (as of November 2022).
120
100
80
60
40
20
0
2008-09
2010-11
2012-13
June 2010
2014-15
2016-17
Successive forecasts
2018-19
2020-21
November 2022
2022-23
2024-25
Outturn data
2026-27
UK public sector debt interest, £billion
Successive forecasts.
Fiscal: £ billion (unless otherwise stated)
Economy: Percentage change on previous year (unless otherwise stated)
160
140
120
100
80
60
40
20
0
2008-09 2009-10 2010-11 2011-12 2012-13 2013-14 2014-15 2015-16 2016-17 2017-18 2018-19 2019-20 2020-21 2021-22 2022-23 2023-24 2024-25 2025-26 2026-27 2027-28
June 2010
Successive forecasts
November 2022
Outturn data
The Debt Crisis in Greece
Greece: government debt to GDP ratio, 1980-2023
Greece: 10 year government bond yield.
Greece: government spending as % of GDP; 1995-2023
Greece: government budget deficit as % of GDP. 1995-2021
The UK’s self-inflicted financial crisis of September-October 2022.
■ Liz Truss become UK Prime Minister on 6th September after promising to cut taxes and stimulate
economic growth. She appoints Kwasi Kwarteng as Chancellor of the Exchequer (Minister of
Finance).
■8th September she announces a scheme to limit energy price rises (potentially big spending).
■23rd September Kwarteng delivers a “mini budget” with £45 billion of tax cuts…..but with no OBR
assessment and having fired the head of HM Treasury.
■26th September the £ hits an all-time low against the $.
■28th September the Bank of England intervenes to stop the value of GILTS falling with up to £65
billion intervention…..the drop in gilts values was threatening solvency of major pension funds.
■29th September Truss says sticking to plans and assessment to be released on 23rd November.
■3rd October U-turn on cuts to top rate income tax.
■10th October assessment of budget brought forward to 31st October.
■11th October Bank of England announces wider intervention in bond market.
■12th October further Truss speech on “no plan to change” .
■14th October Truss sacks Kwarteng and drops corporation tax cut.
■17th October Hunt reverses most of mini-budget measures.
■20th October Truss quits as Prime Minister…….markets recover.
Truss and the Markets: UK and US 30 year bond yields
6
5
4
3
2
1
0
31.12.2021
31.01.2022
28.02.2022
31.03.2022
30.04.2022
31.05.2022
UK 30yr
30.06.2022
US 30yr
31.07.2022
31.08.2022
30.09.2022
31.10.2022
£/$ Exchange Rate
1,4
1,35
1,3
1,25
1,2
1,15
1,1
1,05
1
31.12.2021
31.01.2022
28.02.2022
31.03.2022
30.04.2022
31.05.2022
30.06.2022
31.07.2022
31.08.2022
30.09.2022
31.10.2022
Governments have many aims in their actual fiscal policies:
The Autumn Statement 2022 comes at a time of significant economic challenge for the UK and global economy. Putin’s illegal war in Ukraine
has contributed to a surge in energy prices, driving high inflation across the world. Central banks are raising interest rates to get inflation under
control, which has pushed up the cost of borrowing for families, businesses and governments. Growth is slowing and the International
Monetary Fund (IMF) expects a third of the global economy to fall into recession this year or next.
This comes against a backdrop of higher levels of government debt due to the economic impacts of the COVID-19 pandemic and current
energy crisis. Debt interest spending is now expected to reach a record £120.4 billion this year. These factors have contributed to a significant
gap opening between the funds the government receives in revenue and its spending.
The government’s priorities are stability, growth and public services. Economic stability relies on fiscal sustainability – and the Autumn
Statement sets out the government’s plan to ensure that national debt falls as a proportion of the economy over the medium term. This will
reduce debt servicing costs and leave more money to invest in public services; support the Bank of England’s action to control inflation; and
give businesses the stability and confidence they need to invest and grow in the UK.
To achieve this aim, the government has reversed nearly all the measures in the Growth Plan 2022. The Autumn Statement sets out further
steps on taxation and spending, ensuring that each contributes in a broadly balanced way to repairing the public finances, while protecting the
most vulnerable. The government’s approach to delivering fiscal sustainability is underpinned by fairness, with those on the highest incomes
and making the highest profits paying a larger share.
The Autumn Statement reduces the income tax additional rate threshold from £150,000 to £125,140, increasing taxes for those on high
incomes. Income tax, National Insurance and Inheritance Tax thresholds will be maintained at their current levels for a further two years, to April
2028. The government will also reduce the Dividend Allowance and Capital Gains Tax Annual Exempt Amount.
Businesses must also pay their fair share. The Autumn Statement fixes the National Insurance Secondary Threshold at £9,100 until April 2028.
The government will implement the OECD Pillar 2 rules, to deliver a global minimum corporate tax rate of 15%. R&D tax credits will be
reformed to ensure public money is spent effectively and best supports innovation.
The Autumn Statement sets out reforms to ensure businesses in the energy sector who are making extraordinary profits contribute more. The
Energy Profits Levy will be increased by 10 percentage points to 35% and extended to the end of March 2028, and a new, temporary 45%
Electricity Generator Levy will be applied on the extraordinary returns being made by electricity generators.
While taking these necessary steps, the government also recognises that businesses are facing significant inflationary pressures. The Autumn
Statement sets out a package of targeted support to help with business rates costs worth £13.6 billion over the next 5 years. The business
rates multipliers will be frozen in 2023-24, and upward transitional relief caps will provide support
to ratepayers facing large bill increases following the revaluation. The relief for retail, hospitality and leisure sectors will be extended and increased,
and there will be additional support provided for small businesses.
The government is taking a balanced approach between revenue raising and spending restraint, whilst protecting vital public services. The Autumn
Statement confirms that total departmental spending will grow in real terms at 3.7% a year on average over the current Spending Review period.
Within this, departments will identify savings to manage pressures from higher inflation, supported by an Efficiency and Savings Review.
To help get debt falling, for the years beyond the current Spending Review period, planned departmental resource spending will continue to grow, but
slower than the economy, at 1% a year in real terms until 2027-28. Total departmental capital spending in 2024-25 will be maintained in cash terms
until 2027-28, delivering £600 billion of investment over the next 5 years. This includes maintaining the government’s commitments to deliver major
infrastructure projects.
While delivering overall spending restraint, the government is prioritising further investment in the NHS and social care, and in schools. Supporting
these two public services is the government’s priority for public spending.
The Autumn Statement makes up to £8 billion of funding available for the NHS and adult social care in England in 2024-25. This includes £3.3 billion
to respond to the significant pressures facing the NHS, enabling rapid action to improve emergency, elective and primary care performance, and
introducing reforms to support the workforce and improve performance across the health system over the longer term.
The NHS’s performance is closely tied to that of the adult social care system, so the government will also make available up to £4.7 billion in 202425 to put the adult social care system in England on a stronger financial footing and improve the quality of and access to care for many of the most
vulnerable in our society. This includes £1 billion to directly support discharges from hospital into the community, to support the NHS.
The Autumn Statement announces a real-terms increase in per pupil funding from that committed at Spending Review 2021. The core schools
budget in England will receive £2.3 billion of additional funding in each of 2023-24 and 2024-25, enabling schools to continue to invest in high quality
teaching and to target additional support to the children who need it most.
The government has taken unprecedented steps to help households deal with rising living costs and the energy crisis in 2022-23. The level of
spending seen this year, if sustained over time, would add further upward pressures on inflation and interest rates and risk excessively burdening
future generations with higher debt. The Autumn Statement sets out steps to taper the support next year and make it more targeted to those who
most need it, while also raising more through levies on energy producers.
The Energy Price Guarantee (EPG) will be maintained through the winter, limiting typical energy bills to £2,500 per year. From April 2023 the EPG
will rise to £3,000. With prices forecast to remain elevated throughout next year, this equates to an average of £500 support for households in 202324. On top of this, to protect the most vulnerable, in 2023-24 an additional Cost of Living Payment of £900 will be provided to households on meanstested benefits, of £300 to pensioner households, and of £150 to individuals on disability benefits. The government will also raise benefits, including
working age benefits and the State Pension, in line with inflation from April 2023, ensuring they increase by over 10%.
Alongside direct support, the government is setting a national ambition to reduce energy consumption
by 15% by 2030, delivered through public and private investment, and a range of cost-free and low-cost
steps to reduce energy demand.
Economic growth is the only way to sustainably fund public services, raise living standards and level up
the country. The Autumn Statement sets out measures to boost growth and productivity by investing in
people, infrastructure, and innovation. These include additional support to increase labour market
participation; increasing public investment in infrastructure across this Parliament; delivering planned
skills reforms; and supporting R&D by increasing public funding to £20 billion in 2024-25.
The government will ensure that those sectors which have the most potential for growth - such as
digital, green technology and life sciences - will be supported through measures to reduce unnecessary
regulation and boost innovation and growth. The Autumn Statement also announces the final Solvency
II reforms, which will unlock tens of billions of pounds of investment across a range of sectors.
By taking difficult decisions on tax and spending, the Autumn Statement sets out a clear and credible
path to get debt falling and deliver the economic stability needed to support long-term prosperity.
Mais Lecture at Bayes by Rishi Sunak in February 2022 (links on Moodle).
He expressed a clear commitment to the free market economy and to a high growth and high
productivity route to economic success (with low taxes).
BUT it was not very clear how we get from where we are today (high taxes and slow
growth….expected) to a healthy growing economy.
Strategies based on education and training are fine but will take years.
Tax incentives for higher business investment and innovation make sense but will not necessarily
deliver the required effect (at least not quickly).
Business investment has been very weak for many years and high inflation and pessimistic forecasts
of slow (at best) growth make businesses cautious.
This was partly a political speech to convince the Tory Party that he shares their vision of a low
regulation, and low tax, free market economy. [Despite this he came second in the Tory leadership
contest in summer 2022, but got to be party leader and PM after Liz Truss was forced out in October
2022.]
BUT the paradox is that it is hard to unwind the high tax and high spending cycle that the pandemic
and the energy crisis induced. He was very clear that cutting taxes alone will not produce the growth
(and revenue) to pay for the tax cuts.
Levelling up, green investment, new energy sources, health, social care, education, defence, and
public investment all require high public spending, so paying for this over the next few years while
cutting public debt (and taxes etc) will be a challenge.