Fiscal Policy Essay - Grade: 2.1 PDF

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Fiscal Policy Essay...

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‘My economic team is helping to shape what is going to be a bold agenda to create 2.5 million new jobs, to start helping states and local governments with shovel ready projects’. Obama. a. What is fiscal policy? What is the connection between the government’s deficit and the national debt? Definition of fiscal policy. Fiscal policy involves the government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity. AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M) Fiscal policy aims to stimulate economic growth in a period of a recession andkeep inflation low (UK government has a target of 2%). Basically, fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic cycle. This involves increasing AD. Therefore the government will increase spending (G) and / or cut taxes (T). Lower taxes will increase consumers spending because they have more disposable income - C. This will tend worsen the government budget deficit and the government will need to increase borrowing.

Saving in an economy is non-consumption. National saving is the sum of private saving (Y-T-C) and public saving (T-G). Private saving is the amount of income households have left after paying their taxes and paying for consumption. Public saving is the amount of tax revenue the government has left over after paying for its spending. If taxation revenue is greater than government spending, the government runs a budget surplus. However, if government spending is greater than the money raised from taxation then the government runs a budget deficit because it spends more than it receives. If taxation revenue is less than government spending then there is a deficit. To fund the deficit, governments borrow to cover expenditure, and this adds up to national debt. Deficit is a flow, and national debt is a stock. The national debt is all the deficits combined, culminating as all of the money the government owes. Private debt is not included in the national debt. Deficits are not sustainable. When debt is high, the comparison is usually between the interest rate on national debt and an economy’s growth rate. International repayments will grow and grow relative to the rest of the economy. The government faces a choice to either continue borrowing or to raise taxation; borrowing, however, usually means taxation in the future. b. Why has fiscal policy become more important i) generally in the OECD and ii) specifically within the eurozone? There are two policy instruments with regards to the economy, monetary policy, which focuses on interest rates. In Ireland, monetary policy is set by the European Central bank. Lowering interest rates reduces the cost of borrowing money and thus increases the money supply which in turn increases consumption, investment and net exports. Thus when aggregate demand is low, lowering the interest rate will shift the AD curve to the left. In the last recession, governments dropped interest rates in order to increase the money supply. Interest rates were set almost as low as zero, however, there was a lack of confidence so it didn’t work as borrowing did not increase. In the OECD, with interest rates being cut to zero, there was no significant economic recovery. Thus policy makers could not go much further with monetary policy. As a result, countries began to focus on fiscal policy, especially in the eurozone because the ECB controls the interest rates. Fiscal policy is all about government taxation and spending policies. For example, reducing taxation in a recession in an effort to encourage consumption and thus GDP/economic growth. Increased government spending results in increased aggregate demand. Governments aim to boost demand in a recession. Extra government buying, known and expansionary fiscal policy, has a ‘multiplier effect’ on aggregate demand. Government spending means more income for households, which increases consumer spending. The fiscal multiplier is a measure of how much GDP increases in response to an increase in government spending. 1/1-MPC, with MPC meaning marginal propensity to consume; the income that a household consumes rather than saves. Thus if the government injects 100 billion into the economy, aggregate demand will rise by 400 billion. Greater government spending has an impact on aggregate demand, as G is a component itself, and an indirect

impact, through the multiplier, as it increases consumption. This shifts out the AD curve, boosting output and also increasing prices. Fiscal policy focuses on current and infrastructure spending. Current spending, for example, could focus on wages and salaries. By raising the pay of teachers, doctors, nurses etc., the government can hope to encourage consumption, as they will spend their new wages in the economy, producing growth. As they spend money in shops and restaurants, this in turn increases employment in those sectors, and thus the sectors which provide for them. Infrastructure involves spending on roads and hospitals, this can provide jobs - which, like raising public sector wages, increases consumptions - and also will encourage investment in the country, sound infrastructure is a priority for FDI.

c. Do you think Obama’s shovel-ready plan has been a success or has there been a reassessment of the role for fiscal policy in macroeconomic stabilisation since he spoke? According to Keynes, the economy is unstable. Thus there is a role for government to minimise booms and busts. Stabilisation policies focus on making sure the economy’s short run growth is closer to long run trend growth. Governments aim to reduce economic fluctuations. Fiscal policy is one way of doing this. Fiscal policy is all about government taxation and spending policies. Keynesian cross: .

Planned expenditure (45 degree line) may differ from actual expenditure. If they are equal, employment will equal national income (Y). The 45 degree line is the point where consumption spending equals income. The economy is in equilibrium where expenditure intersects the 45 degree line. If planned and actual expenditure are not equal, the equilibrium income may be below full employment (Y1). Expenditure in an economy is aggregate demand. The components of demand are the same as GDP. Thus expenditure =

C+I+G+NX. There will always be some autonomous consumption. The slope of the AS curve will be less than one, because once people have income they will put some aside in savings. A deflationary gap exists if expenditure is less than the full employment level. If the government spends more, increasing G, this will boost AD and thus expenditure. Keynes argued that recessions and depression can occur because of inadequate aggregate demand. To eradicate a deflationary gap, a government can influence components of aggregate demand through fiscal and monetary policy, bringing the economy closer the Y1, the full employment level, where expenditure and national income are equal. Governments can smooth economic fluctuations; its own spending will have a multiplier effect. This is one, divided by the saving rate. The fiscal multiplier is a measure of how much GDP increases in response to an increase in government spending. 1/1-MPC, with MPC meaning marginal propensity to consume; the income that a household consumes rather than saves. Thus if the government injects 100 billion into the economy, aggregate demand will rise by 400 billion. Greater government spending has an impact on aggregate demand, as G is a component itself, and an indirect impact, through the multiplier, as it increases consumption. This shifts out the AD curve, boosting output and also increasing prices. However, if the government borrows, capital will become scarcer for firms and households, and this may result in crowding out. There are also limits to how much a government is able to borrow. In conclusion, expansionary fiscal policy, mainly more government spending, is an attempt to reduce the deflationary gap - where expenditure is less than full employment and national income - between equilibrium and potential output. However, it has limits, mainly with regards to borrowing. Shortly after his election in 2008, Obama announced plans to introduce an economic recovery programme, focused on infrastructure jobs building bridges and roads, hybrid cars, wind turbine farms and energy conservation schemes amongst many more. Thus Obama gave money to states to spend on capital projects, mostly infrastructure. However, this policy has been deemed a failure. When the president campaigned for the stimulus package at the start of his presidency, he and others in his administration repeatedly insisted the investments would go to "shovel-ready" projects - projects that would put people to work right away. However, local governments were still facing delays after years spending the money they were allocated from the stimulus. This is because of various lagged factors, such as decision-making, planning permission, construction - all of which cause a significant time delay. Another factor was the actual lack of projects to invest in. Far from creating the promised 2.5 million jobs, in 2011 the Bureau of Labor Statistics indicated Obama had actually destroyed 2.8 million jobs. In 2010, Obama acknowledged, ‘there are no such thing as shovel-ready projects. Debt in the Eurozone, as a result of the Stability and Growth pact, must be less than 60% of GDP and the deficit must be less than 3% of GDP. As Ireland borrows for infrastructure, the debt increases. Deficits rise in recessions, whilst taxation income declines because of a decline in income tax and VAT, for example. Thus in these situations where stabilisation is required, it is very difficult to get projects ‘shovel- ready’. To invest further in infrastructure

would increase the deficit and the national debt, and governments find it hard to raise money for projects when they have a high debt because of the lack of confidence in the system. Thus these shovel-ready projects can’t be financed through borrowing. Most countries can only borrow at most 10% of their GDP for a few years before causing a great loss in confidence. In Ireland, between 1994-2007, Ireland had stable national debt. Rapid economic growth meant that the debt to GDP ratio fell from 90% to 25%. Since 2007, however, GDP has increased rapidly from 47 billion euros to 216 euros in 2013. In the 90s, there had been rapid growth and thus high expansion in public spending. The rapid growth boosted tax revenues, however, these were mainly temporary - income tax, for example- and declined as boom ended. Much of the Irish government's revenue was temporary, but a government’s spending commitments are largely permanent; for example, now much spending is focused on the old, the young, and the unemployed. At the end of the boom, there was a gap in what the government earned and what it spent. It is difficult to cut spending dramatically, and Ireland’s two main tax rates (VAT and income) are already very high by OECD standards. This limits what can be done to encourage economic growth. Growth requires a bigger GDP - i.e. more income and expenditure - meaning there is a need for more income tax and VAT revenues. Marginal income rate of tax is high, but the average rate is not. The three main rates are income, consumption and wealth. Most wealth in Ireland is in property, which also reflects local services and amenities. Thus a higher property tax is one remedy for Ireland’s deficit. Criticisms: 1. The government may have poor information about the state of the economy and struggle to have the best information about what the economy needs. 2. Time lags. To increase government spending will take time. It could take several months for a government decision to filter through into the economy and actually affect AD. By then it may be too late. 3. Crowding out. Some economists argue that expansionary fiscal policy (higher government spending) will not increase AD, because the higher government spending will crowd out the private sector. This is because government have to borrow from the private sector who will then have lower funds for private investment. 4. Government spending is inefficient. Free market economists argue that higher government spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to reduce spending in the future because interest groups put political pressure on maintaining stimulus spending as permanent. 5. Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments....