Chapter Seven Answers
1.
a. Suppose that the economy expands strongly due to a building boom. Demonstrate on
both a government spending tax diagram and on a fiscal stance diagram what could be
expected to happen to the budget balance.
The economy expands and the budget balance improves
$
T = tY
original
surplus
at Y1
surplus at Y2
G1
Y1
Y
Y3
FS1
T-G
FS2
Surplus
surplus at Y2
0
Y
Deficit
The government’s tax take increases as the multiplier effect from the building boom increases
GDP. The measured surplus rises at Y2
b. Suppose that the government is pursuing a contractionary fiscal policy. Show how an
increase in the actual fiscal deficit may arise.
In this case the initial fall in G or rise in T would reduce the existing budget deficit or
make the surplus bigger if the economy stayed in the same place. The contraction
however will cause the economy to shrink. This will reduce the tax take and if the
contraction is severe enough may ensure that the economy ends up with an even
bigger deficit despite the contractionary fiscal stance
Suppose the economy is initially at Y1 with government spending at G1 and a given tax
rate or T line. The government can increase taxes- shifts the T line up or reduce
spending- shifts the G line down. If the government reduces its spending, G1 falls to
G2 and if the economy stayed at Y1 the surplus would increase. But the move
contracts the economy and Y falls. At Y2 there is a still a surplus, but if the contraction
is severe and the economy ends up at Y3, a deficit emerges.
Contractionary fiscal policy and the budget balance
$
T = tY
surplus at Y1
G1
G2
deficit
at Y3
Y3
Y
Y1
Y2
T-G
FS2
FS1
Surplus
surplus at Y1
0
deficit
at Y3
Y
Y3
Y2
Y1
Deficit
2.
In regard to government expenditure, what do the following terms mean:
a. exhaustive expenditure
Direct expenditure on resources (current and capital).
b. transfer expenditure
Benefits or subsidies. Can be regarded as negative taxes or flows from the
government that offset taxes paid. Includes interest on the public debt.
c. financial expenditure
Not part of government’s current expenditure – includes purchases of shares
and lending, e.g. to students.
3. Suppose that the government spends $10,000m on operating expenses, sells assets worth
$2000m and has current revenue equal to $11,000m. During the year the state builds a
new motorway valued at $3000m and lends $500m to students.
At the end of the year the balance sheet shows:
student loans = $2500m
other state assets less depreciation = $45,000m and
public debt = $50,000m.
Determine:
a. the operating balance
operating balance = current income – current expenses.
current revenue – operating expenses = 11,000 – 10,000 = +$1000m
operating surplus
b. net worth
net worth = Crown Balance = assets (including loans made to others) –
liabilities (public debt). From end of year balance sheet
net worth = assets – liability = 45,000 + 2500 – 50,000 = –$2500m.
This is negative – of course there are debates about how assets are valued
and does not mean state is bankrupt.
c. the amount that the state had to borrow this year
borrowing = difference between cash in and cash out.
cash in = income + asset sales = 11,000 + 2000 = $13,000m
cash out = current expenses + asset purchases = 10,000 + 3000 + 500 =
$13,500m
cash flow = 13,000 – 13,500, so need to borrow $500m.
d. the change in assets, debt and net worth.
change in assets: increase 3500 (new motorway + new loans) and decrease
2000 (asset sales)
change = + $1500m
change in debt = new borrowing = $500m
change in net worth = change in assets – change liabilities = +$1000m (must
equal operating surplus).
4
Explain the difference between the
a. Structural surplus,
b. the operating surplus and
c. the OBERAC
The Structural surplus is the balance that would occur if the economy was operating at a
‘normal’ or trend rate of activity sometimes taken as ‘full employment’. It removes the
impact of the state of the economy on the measured surplus (or deficit as the case
maybe).
The operating surplus is that recorded in the government’s budget and will reflect the
fiscal stance and the state of the economy. In recessions once expects the surplus to be
smaller or the deficit to be larger than in booms. Today this is measured using proper
accounting conventions including any change in the net present valuation of the
outstanding future claims such as for ACC and government employees’ pensions.
The OBERAC is the operating balance excluding revaluations and accounting changessuch as the net present value of future claims for ACC that in turn only reflect changes
in the interest rate used to discount these obligations.
5
Suppose that the government projects an increasing structural surplus over the next five
years. If no other sectors change what is the likely impact on the economy?
An increasing structural surplus indicates that the fiscal stance is contractionary. If no
other sector such as the export sector or domestic investment or household
consumption increases the economy can be expected to contract
6
a. In the 1990s the government financed some of its budget deficit by selling
assets. What were some of the problems associated with asset sales?
Assets sold in a fire sale situation are unlikely to achieve book value, let
alone true worth. This is a criticism of many of the asset sales in the 1980s and 1990s.
They may assist the government cashflow, but if sold for less than true value they will
detract from the operating surplus with short-term gain at the expense of longer-term
losses..
When sales are made to foreigners there is initially a net increase in resources
available to the economy and foreign owners may introduce new technology to the
economy. In subsequent years the outflow of dividends to the foreign owners will be a
negative influence on the CAD, largely beyond the control of government policy.
Foreign ownership of New Zealand assets will increase as happened in the 1980s and
throughout the 1990s. While both foreign and domestic owners would have a basic
interest in maximising profits, foreign owners may be less committed to the long-term
future of the economy and may be inclined to emphasise high short-term gains at the
expense of longer-term growth potential.
b. In the early 2000s, the government generated budget surpluses. And used
some of this to acquire assets. What possible problems might be associated
with increasing state assets such as student loans, investment in the New
Zealand Superannuation Fund, the new Kiwibank and the purchase of 80%
of Air New Zealand’s shares
Among the possible problems is the return to state control over essentially commercial
activities. In the case of student loans while they are an asset for the government they are
nor an asset for New Zealand as a whole as they are cancelled out by the debt held by
students. The NZ Superannuation Fund suggests that the government is entering into a
new role of investment in financial assets which may be high risk. The Kiwbank is an
area that some may dispute is the role of the state, in appealing to low income depositors
it may be a low profit venture. The ownership of Air New Zealand shares may raise
concerns about loss of competition and future liabilities to tax payers, but note that the
government bought in at a low prices.
7
Suppose the government has a large operating surplus. What are its options? What are
the advantages and disadvantages of each of these and what factors should be taken into
account in deciding what to do
It might:
a. Use the surplus to repay debt
b. Use the surplus to buy real and financial assets
c. Use the surplus to invest in infrastructure
d. Reduce taxes
e. Increase current spending
Of these options, if there are profitable investments to be undertaken that given a better
return than repaying debt then investing in these may make sense. A factor to take into
account is the size of the public debt. Investing in road and electricity supply may be
sound investments for the future growth of the economy. Note that if the economy is at
full employment, the spending on capital items such as roads and hospital buildings is
more expansionary and hence inflationary than merely buying financial assets or
repaying debt. Thus the government must look at the state of the economy. Likewise it
may be inappropriate to give tax cuts or increase spending. Note that there two options
will reduce the surplus rather than be a use of it.