Lecture notes
Prepared by Anton Ljutic
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Fiscal Policy
CHAPTER ELEVEN
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•Understand why the federal government’s revenuedepends on the rate of taxation, the size of theGDP, and its own spending
•Explain the pros and cons of a budget policyaimed at achieving
–full-employment equilibrium
–a balanced budget in each fiscal year
–both full employment and a balanced budget over thelife of the business cycle
•Discuss the cause, size and problems of thenational debt
This Chapter Will EnableYou to:
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Fiscal Policy and the Budget (I)
•Fiscal policy
–The government’s approach toward its ownspending and taxation
•Budget balance
–Is the difference between net tax revenues andgovernment spending (NTR – G)
•Net tax revenue
–Total tax revenue received by government lesstransfer payments
NTR = tax revenue – transfer payments
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Fiscal Policy and the Budget (II)
•Budget deficit
–Government spending on goods and services inexcess of net tax revenues
•Budget surplus
–Net tax revenue in excess of governmentspending on goods and services
•National debt
–The sum of the federal government’s budgetdeficits less surpluses
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Changes in the Economy and GovernmentRevenues (I)
G
G, NTR
Surplus: NTR G
NTR
Deficit
NTR < G
Real Y
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Changes in the Economy and GovernmentRevenues (II)
•Balanced budget
–The equality of net tax revenues andgovernment spending on goods and services
•Monetizing the debt
–The action by government of borrowing fromthe central bank to finance increased spending
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Counter-Cyclical Fiscal Policy (I)
•Deliberate adjustments in the level ofgovernment spending and taxation in orderto close recessionary or inflationary gaps
•A policy used by governments in manycountries since World War II
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Counter-Cyclical Fiscal Policy (II)
•Dealing with arecessionary gap bymeans of fiscalpolicy, i.e., byraising G and/orlowering T.
•The gap is equal
to YFE minus Y1.
•Dealing with arecessionary gap bymeans of fiscalpolicy, i.e., byraising G and/orlowering T.
•The gap is equal
to YFE minus Y1.
YFE
Y1
P
Real Y
AD1
AD2
AS1
Potential GDP
Figure 11.2
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Counter-Cyclical Fiscal Policy (III)
•Dealing with aninflationary gap bymeans of fiscalpolicy, i.e., bylowering G and/orraising T.
•The gap is equal
to Y1 minus YFE.
•Dealing with aninflationary gap bymeans of fiscalpolicy, i.e., bylowering G and/orraising T.
•The gap is equal
to Y1 minus YFE.
YFE
Y1
P
Real Y
AD1
AD2
AS1
Potential GDP
Figure 11.3
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Criticisms of Counter-Cyclical Fiscal Policy
•effective but subject to serious time lags
•ineffective because it may be inflationary,crowds out private investment spending andthus reduces the multiplier
–The crowding out effect
•The idea that government borrowing to finance adeficit crowds out private investment because itcauses interest rates to rise
•can cause serious budget deficits
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Balanced-Budget Fiscal Policy (I)
•The belief that a government’s budgetshould be balanced in each budget period
•Advocates of this policy use threeobservations to support their position:
1.Counter-cyclical philosophy adversely affectspeoples’ incentives and warps their sense ofresponsibility
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Balanced-Budget Fiscal Policy (II)
2.The economy has effective automaticstabilizers
•Automatic stabilizers
–Government policies and programs thatautomatically change with the state of theeconomy so as to stabilize the economy
3.The economy is capable of returning to full-employment equilibrium through a self-adjustment process
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Criticisms of Balanced-Budget Fiscal Policy (I)
•A balanced-budget fiscal policy will likelybe pro-cyclical in circumstances in whichthe economy is experiencing a recessionarygap, since trying to eliminate the resultingbudget deficit will lead to an even biggerrecession
–Pro-cyclical
•Action by the government that tends to push theeconomy in the same direction it is leaning in
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Criticisms of Bal.-Budget Fiscal Policy (II)
•This policy will also be pro-cyclical whenthe economy is experiencing an inflationarygap
•If the inflationary gap comes with a budgetsurplus, this policy will also be pro-cyclical
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The Arithmetic of a Balanced Budget
•What would be the impact on GDP of
a. A same-amount increase in G and T?
b. A same-amount cut in G and T?
•The answer is NOT “no effect”.
•The multiplier set in motion by a change in G islarger than the one created by a change in T
•The answers to the above questions are:
a.If +G = +T, GDP will rise
b.If - G = - T, GDP will shrink
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Cyclically Balanced-Budget Fiscal Policy
•The use of counter-cyclical fiscal policy to balancethe budget over the life of the business cycle
•Potential problems:
–There is no guarantee that the size and the length of therecessionary gap, when the government is running abudget deficit, will be exactly offset by the size and thelength of the inflationary gap when the government isrunning a budget surplus
–Most governments find it easier to increase spending inbad times than to decrease it in good times
–The political cycle does not correspond to the businesscycle, so that one government might leave the problemof balancing to the next government.
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Fiscal Policy and the National Debt (I)
•The problems with high deficits and debt:
–The potential crowding out of private investmentspending and net exports
–The interest payments that must be paid out on theforeign-held debt
–The income redistribution effects of large interestpayments
–The reduced ability of government to meet the needs ofits citizens
–The potential inflationary effects
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Fiscal Policy and the National Debt (II)
•Misconceived Problems With The NationalDebt:
–Suggestions that if revenue falls short ofexpenses for a long period of time, thenbankruptcy will follow
–Claims that we are encumbering futuregenerations who will eventually have to pay forthe debt
–Looking at the debt in isolation from Canada’sGDP
© 2004 McGraw–Hill Ryerson Limited
•Understand why the federal government’s revenuedepends on the rate of taxation, the size of theGDP, and its own spending
•Explain the pros and cons of a budget policyaimed at achieving
–full-employment equilibrium
–a balanced budget in each fiscal year
–both full employment and a balanced budget over thelife of the business cycle
•Discuss the cause, size and problems of thenational debt
Chapter Summary:What to Study and Remember