MACROECONOMIC POLICIES AND PROBLEMS Managing the Economy How? 11/21/20161

Fiscal policy Govt spending (G) & tax collections (T) to achieve macroeconomic goals. Policy setting Formulated & implemented by Finance Minister. G & T have to be approved by Parliament. 11/21/20162

Fiscal policy Discretionary fiscal policy (Active) –Implemented at the discretion of the govt according to its target objectives. –Changing G & T depending on the state of the economy. –E.g. Reduce T during recession. Govt uses its discretion.. 11/21/20163

Fiscal Policy Automatic fiscal stabilisers (passive) -Fiscal policy is built into the structure of Govt taxes and spending. - Tax stabilisers (PAYE) -Benefits stabilisers (UE benefits) -These act to increase AD in recessions, and to decrease AD in overheated expansions. 11/21/20164

Basic Theory of Fiscal Stabilisation -Designed to reduce economy’s cyclical fluctuations (recessionary & inflationary gaps) -G and T affect both AS and AD. Policy options : ↑G only; ↑ T only; ↑ G and ↑T – Balanced budget ↑ G and ↓T – Budget deficit ↓G and ↑T - Budget surplus 11/21/20165

Fiscal Policy Closing recession gap: 3 ways Pvt sector demand recovers. Excess SS of factors causes factor prices to fall. Lengthy due to wage stickiness.  auto-correction (mkt forces). Govt intervention (Keynes). 11/21/20166

Fiscal policy a)Closing gap: Market forces 11/21/20167 AS1 AS0 E0 E1 YfY0Real GDP Price level P0 P1 AD

Fiscal Policy b) Expansionary policy. -Govt cannot wait for the recessionary gap to correct itself. -Either ↓T or ↑G to stimulate AD. 11/21/20168

Illustration 11/21/20169 AS0 AD 1 AD0 E2 E0 Real GDP Price level YfY0 P0 P2

Fiscal Policy Advantage: shorten what might be a long recession. Disadvantage : May stimulate economy just before the private sector spending recovers thus overshooting potential output. Meant to promote economic stability but can actually cause instability. 11/21/201610

Fiscal Policy Expansionary FP creates a budget deficit. Contractionary fiscal policy creates a budget surplus. Deficits & surpluses are a burden to govt and can cause serious economic problems. Expansionary effect of deficit spending depends on the method used to finance the deficit. Anti-inflationary effect of surplus depends on how the surplus is disposed. 11/21/201611

Financing of Deficits a)Borrowing from the public -Govt borrows from money market. -Competes for funds with the private business borrowers. -Interest rates ↑ & crowd-out private investment & consumer spending. -Fall in private spending weakens expansionary effect of the deficit spending.  Adv: Not potentially inflationary.  Disadv: Accumulating debt (debt trap). 11/21/201612

Financing of Deficits b) Money creation -RBZ prints money to finance the deficit (seigniorage revenue). Adv: No crowding-out effect (more expansionary). Disadv: Potentially inflationary. 11/21/201613

Disposing of Surpluses a)Debt reduction -Money is transferred back to the money market, i falls, borrowing and spending rise (↑AD). -Could be inflationary -↑AD somewhat offsets the contractionary FP that created the budget surplus. 11/21/201614

Disposing of Surpluses b) Idle surplus (impounding) -Holding idle surplus: extracting & withholding purchasing power from the economy. -No possibility for surplus to create inflationary pressure that offsets the anti-inflationary effect of contractionary FP. 11/21/201615

Effectiveness of fiscal policy a)Timing - Long Admin lag. Economic situation may have changed by time of approval. - Shorter operational lag as compared to MP, eg tax reductions, G on public works. b) Political business cycles. -Politicians will manipulate FP to maximise voter support even though the decision destabilises the economy. -E.g. Huge subsidies, tax cuts, increase G towards elections → populist policies. 11/21/201616

Effectiveness of fiscal policy c) Crowding out effect -Deficit spending forces interest rates to rise crowding-out private investment. -FP may be largely ineffective. d) Unforeseen events -Droughts, diseases, wars render tight FP ineffective. 11/21/201617

Effectiveness of fiscal policy Effectiveness of automatic stabilisers The problem of fiscal drag: the process by which rising incomes draw people into higher tax brackets, so that their real incomes may fall, this acts as a restraint on the expansion of the economy. 11/21/201618

Monetary Policy and Fiscal Policy Policy complementarity -Tight MP must be accompanied by tight FP. -Both policies should be designed to achieve the same goal. 11/21/201619