Fiscal Policy
Fiscal Policy
• The government directly controls its own
expenditure and can thereby directly affect
aggregate demand.
• The government controls the tax levels and
therefore they can indirectly impact the
spending of households that pay taxes.
– Expansionary policy: Increase spending, cut
taxes.
– Contractionary policy: Decrease spending, raise
taxes
Sources of Revenue HK 2004/2005
Land Premium &
Sales
20%
Profit Tax
24%
Investment Income
10%
Betting, Fees,
Duties
25%
Salaries Tax &
Property, Other
21%
HK Government Outlays by
Category 2005/06
Support
12%
Community Affairs Economic
3%
6%
Social Welfare
14%
Education
22%
Security
10%
Infrastructure
10%
Environment and
Food
4%
Housing
6%
Health
13%
Stabilization policy
• In an economy subject to shocks to aggregate
demand (animal spirit shocks, external shocks,
asset market shocks), the economy will have a
self-correcting mechanism.
• However, if this self-correction mechanism
takes a long time to work, then government may
use policy to speed adjustment.
– Use expansionary policy to close a recessionary gap
– Use contractionary policy to close an inflationary
gap
Demand Driven Recession
Counter-cyclical fiscal policy
YP
P
3
P*
1
2
Y*
Recessionary Gap
SRAS
w/
1. Economy in LT
equilibrium
2. Demand shifts
in
3. Government
increases
AD spending to shift
the AD curve
back
AD′
Y
Demand Driven Expansion
Counter-cyclical fiscal policy
YP
P
SRAS
1. Economy in LT
equilibrium
2. Demand shifts
out
2
P*
3. Government
cuts spending to
shift the AD
AD′ curve back
1
3
Y*
w/
AD
Inflationary Gap
Y
US Recessions are becoming shorter
as stabilization policies were adopted.
Average Length of Contraction
25
Months
20
15
10
5
0
1854-1919
1919-1945
1945-2001
Lags and Fiscal Policy
• Administrative lags for fiscal policy may likely be large.
• Except in absolute dictatorships, government will have
mechanisms for building a consensus for expenditures.
Adjusting this consensus will be time consuming.
• If lags are too long, stabilizing government spending or
transfer payments may have a destabilizing effect,
shifting out demand after the economy has already
recovered.
Automatic Stabilizers
• Taxes are usually collected as a fraction of
incomes of households. Even if the
government keeps the tax rate unchanged.
– When the economy goes into a boom, taxes are
automatically raised mitigating the effects of
the boom.
– When the economy goes into a recession, taxes
are automatically cut, ameliorating the
recession.
Budget Deficit
• Governments in most economies issue debt to
make up for shortfalls in revenues in relation to
spending.
Budget Deficit = Expenditures – Taxes
• Tax collection is cyclical so the budget deficit
tends to be counter-cyclical.
• Maintaining a balanced budget over the cycle
means raising taxes in a recession an cutting taxes
in a boom which makes the business cycle more
extreme.
Procyclical Budget Surplus in HK
.12
.08
.04
.00
-.04
-.08
1990 1992 1994 1996 1998 2000 2002 2004 2006
Budget Surplus (as a % of GDP)
Detrended GDP
Turkey
Thailand
Singapore
Poland
Peru
Mongolia
Israel
India
Cote d'Ivoire
Chile
Botswana
Belarus
Albania
180
160
140
120
100
80
60
40
20
0
%
Most Economies Have Positive
Government Debt.
Debt/GDP
Hong Kong Has Traditionally had negative Debt.
Government Wealth
800000
700000
600000
500000
400000
300000
200000
100000
19
86
19
87
19
88
19
89
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
0
Why would a persistent deficit be a
problem?
Two Reasons
1. High government borrowing may push up
interest rates and crowd out investment
2. High government borrowing means that
the interest obligations of the government
will rise.
Example: US Government runs a deficit
to finance military spending
r
S´
S
I
r**
r*
LF**
LF*
LF
Problem
• Compare budget deficit in a globalized
economy with deficit in closed economy.
• What are the differences in impact on
investment and real interest rates?
-1.00%
-2.00%
-3.00%
-4.00%
-5.00%
-6.00%
-7.00%
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
Budget Surplus in USA
(as a % of GDP)
0.00%
Government Interest Payments per
US Resident
$1,000.00
$900.00
$800.00
$600.00
$500.00
$400.00
$300.00
$200.00
$100.00
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
$0.00
1975
1996 US$
$700.00
Learning Outcomes
• Students should be able to:
• Explain the uses of counter-cyclical fiscal
policy in stabilization.
• Explain the effect of budget deficits on real
interest rates on capital markets.
• Explain the negative effects of long-term
budget deficits.