Fiscal Policy and the Business Cycle Changes in the AS/AD curves cause actual real GNP to swing...
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Transcript of Fiscal Policy and the Business Cycle Changes in the AS/AD curves cause actual real GNP to swing...
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
Growth rate ofpotential GDP
Actual growth rateInflation gap
Unemployment gap
Time
%change
Stabilisation policy
5 – 6%
Boom
Recession
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
Government expenditure (G)
GNP1
AB
GNP2
C
Nominal GNP
NT
GNP
€ billions
Full-employment budget
G, NT
Budget surplus
Budget deficit
*
Natural GNP
Balanced budget
Leddin and Walsh Macroeconomy of the Eurozone, 2003
Government expenditure (G)
GNP1
AB
GNP2
C
Nominal GNP
NT
GNP
€ billions
Discretionary changes in taxes and expenditure
G, NT
*
Natural GNP
NT
NT
1
2
3
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
Natural growth rate
Actual growth rate
Economy hit by “shock” goes into recession
Expansionary fiscal policyimplemented at this point
Time
%change
How a stabilisation policy de-stabilises the business cycle
5 – 6%
Boom
Business cycleautomatically rights itself
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 mid-1980’s.
Leddin and Walsh Macroeconomy of the Eurozone, 2003
Averagetax rate
100%
0 %
T
T
T
1
*
2
R 1 R 2
Revenuemaximizingtax rate
Tax revenue £m
A
B
Laffer Curve
Z
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
• 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
ttttt grdd )(
Primary Balance % GDP
-15
-10
-5
0
5
10
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Year
% G
DP
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