Fiscal Policy and the
Business Cycle
• Changes in the AS/AD curves cause actual real GNP to
swing around natural real GNP.
• That is, the business cycles tends to move from recession
to boom and back again.
• According to Keynesian theory, these booms/recessions
can persist for long periods of time.
• Keynesians advocate an active fiscal policy (changes in
government expenditure and/or taxes) to try to stabilise the
business cycle.
• This keeps actual GNP close to natural GNP over time.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Stabilisation policy
%
change
Boom
Inflation gap
Actual growth rate
5 – 6%
Growth rate of
potential GDP
Unemployment gap
Recession
Time
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Assessing the Stance of Fiscal
Policy
•
•
•
•
•
•
•
•
A recession automatically worsens the budget deficit. Tax
revenues fall and social welfare spending rises.
Boom period, the deficit falls.
Define: Budget surplus = T – [G + SW]
Defining net taxes (NT) as:
NT = T – SW
NT is the proportion of government tax revenue and
spending that varies with fluctuations in nominal GNP.
Positive relationship between NT and GNP.
Current spending (G) is assumed to be constant.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Continued
•
•
•
•
•
•
Diagram shows how the budget balance varies as GNP
changes. (Diagram 1)
Recession: Budget deficit.
Boom: Budget surplus.
Note distinction between automatic and discretionary
changes in the budget balance. (Diagram 2)
Discretionary change occurs when the government
deliberately changes G, T or SW.
The result is a balanced budget at different levels of GNP.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Full-employment budget
G, NT
Natural GNP
NT
€ billions
Budget surplus
B
A
Government
expenditure (G)
C
Budget deficit
Balanced budget
GNP
1
GNP*
GNP
2
Nominal GNP
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Discretionary changes in taxes and expenditure
NT2
Natural GNP
G, NT
NT
1
NT
3
€ billions
B
GNP1
A
C
GNP *
GNP2
Government
expenditure (G)
Nominal GNP
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Natural GNP Budget
•
•
•
•
•
At what level of GNP should the government attempt to
balance the budget?
It is argued that the relevant budget balance is the natural
GNP budget surplus.
That is, the government should choose a combination of
taxes and expenditure that balances the budget if the
economy were at natural real GNP.
This entails tolerating a deficit in times of recession and a
surplus when the economy is over-heating.
The problem is that it is not easy to calculate the natural
GNP budget.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Problems Encountered in
Stabilising the Business Cycle
• The government is counter-acting shifts in either
the AS or AD curves using only fiscal policy.
• However, this is not an effective response to
dealing with an adverse supply-side shock.
• It solves the real GNP/unemployment problem but
it makes inflation worse.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Policy Lags
• Recognition lag: a delay in realising the economy has
gone into boom or recession. Data is out-of-date.
• Decision lag: a delay in deciding how to spend, cut
expenditure or change tax rates.
• Implementation lag: for instance, tenders for projects
delay expenditure.
• Outside lags: the time policy takes to impact on the
economy.
• Government policy could be out-dated by the time it is
implemented and could end up destabilising, rather than
stabilising, the business cycle.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
How a stabilisation
policy de-stabilises
the business cycle
%
change
Economy hit by “shock”
goes into recession
Boom
Actual growth rate
5 – 6%
Natural growth rate
Expansionary fiscal policy
implemented at this point
Business cycle
automatically
rights itself
Time
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Continued
• Changes in taxes can give unpredictable
results. Refer to the Laffer curve.
• Examine relationship between tax rate and tax
revenue.
• Optimal tax rate: T*
• Below optimal: normal positive relationship.
• Above optimal: an increase in tax rate may lead to
a decrease in tax revenue. High taxes affect the
“incentive to work” and drive industry into the
black economy, as we saw in Ireland in the mid1980’s.
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Laffer Curve
Average
tax rate
100%
A
T1
Z
T*
T2
Revenue
maximizing
tax rate
B
0%
R1
R
2
Tax revenue £m
 Leddin and Walsh Macroeconomy of the Eurozone, 2003
Dynamically Unstable Debt
• Problem with Fiscal policy in recession
• Debt grows exponentially as economy declines
and we borrow merely to pay interest on the
stock of debt
– Problem in 1980s
– Could be problem again
• Key variable is d=D/Y
– Debt-GDP ratio
– “debt burden”
• d evolves according to the following equation
dt  dt (rt  gt )  t
• Where
– r is the interest rate
– g is the growth rate
– p is the “primary balance”: G-T excl. interest
• Difference equation with impulse and potentially
explosive growth
• Intuitive
– Maths online
-5
-10
-15
Year
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
% GDP
Primary Balance % GDP
10
5
0
Fiscal rules
Just as monetary policy has been taken
over by independent central banks, out of
the reach of politicians, should fiscal
policy be removed from the political
arena by subscribing to a fiscal rule?
Alternative fiscal rules
• The EU Stability and Growth Pact
• The Golden Rule
• Stabilize the debt/GDP ratio
• Sustainable investment rule
National fiscal policy and the
Stability Pact
The Stability and Growth Pact (SGP) was
framed at the Dublin summit, December
1996, and ratified at the Amsterdam
Summit, June 1997
Designed to prevent backsliding by
countries that had met the Maastricht
criteria
The SGP
• Formalises the “Excessive Budget
Deficits” procedure
• Fiscal deficits should average at most 1%
of GDP over the business cycle
• Deficits in excess of 3% of GDP will
attract penalties unless they were due to
“exceptional” and/or “temporary”
Could imply pro-cyclical transfers from
countries to the centre.
– Fiscal federalism in reverse
SGP
• Countries have to prepare a Stability
Programme when presenting their
national budgets
• This Programme contains
projections of General Government
Balance for four years showing that
national fiscal policy respects the
SGP
SGP: Rise, Fall and Rise Again
• Ireland was reprimanded in 2001
because the Council felt that Budget
2001 was too expansionary
– But the stagnation of the Eurozone economy
during 2002 has lessened the appetite for
enforcing the SGP
– Portugal, Germany, Italy, and France at or
above the 3% ceiling
• The deadline for reaching a balanced budget postponed from 2004
to 2006
• Then France ignored SGP in formulating its 2003 Budget
– Proposal to Scrap it
– Prodi: “All rigid rules are stupid. The SGP is a rigid rule”
• All changed now because of Greece and Ireland
• Modify it:
– “cyclically adjusted” budget balance, taking account of the automatic
stabilisers
The Golden Rule
• Alternative to SGP
– Was followed by UK
• Over the business cycle the government should borrow
only to invest and not to fund current spending
– No current deficits, but
– Future generations should contribute to the costs of
infrastructure from which they benefit
• We adhered roughly to this rule in Ireland until the late
1970s
• Is being suggested as part of new European rule
Problems with The Golden Rule
• The threshold between current and capital
spending is not hard-and-fast
– Education? Health? Etc
• Is government capital formation efficient?
• Until the crisis government capital formation
accounted for borrowing equal to about 4.5%
of GDP
• What happens if break it? Precedent of SGP
Sustainable Debt Rule
• The debt/GDP ratio will be stabilized at a
“prudent” level.
– Maastricht criterion was 60%
– UK Chancellor (Gordon Brown) defined it as 40%
• There is no well-defined “optimal” level
• And even if there were, it would change over
time
– See the maths of debt dynamics
Conclusion On Rules
• Present Crisis: There is need for a rule
– but a rigid one is undesirable
– Probably unenforceable
• Projections of GDP, tax revenue, and spending
are uncertain
• Rule should force the present generation to pay
for the level of spending on (current) public
services it desires