Fiscal Policy OCR Year 2 Macro

The UK Budget Balance and National Debt Public Sector Borrowing % of GDP Public Sector Net Debt 2007–08 2.7 36.7 2008–09 6.7 49.0 2009–10 10.2 62.0 2010–11 8.6 68.7 2011–12 7.0 72.3 2012–13 7.2 76.7 2013–14 5.7 79.1 2014–15 4.9 80.5 2015–16 4.0 80.2 What is government borrowing? Public sector borrowing is the amount the government must borrow each year to finance their spending What is national debt? Public sector debt is a measure of the accumulated national debt owed by the government sector Source: OBR, July 2015

Countries with Highest Gross Government Debt (2015)

Countries with the Lowest National Debt in 2015

Government Borrowing and Bond Interest Rates When a government borrows it issues debt in the form of bonds. The yield on a bond is the interest rate paid on state borrowing Purchasers of government bonds include pension funds, insurance companies and overseas investors. The % yield on debt has been very low in recent years for countries such as the UK.

Yields on UK Government Bonds The chart shows the per cent yield on a selection of UK government bonds of different maturities

Key Causes of a Budget (Fiscal) Deficit Recession causing rising unemployment Decrease in consumer spending and profits leading to less tax revenue Increase in inactivity leading to rise in welfare benefit spending Use of fiscal stimulus by a government to boost aggregate demand Increase in interest rates on debt leading to a rise in debt service costs Demographic factors causing state pensions to rise

Economic Justifications for Budget Deficits Since 1970, the UK government has had a budget surplus in only six years – it is normal for the government to have to borrow money A rise in borrowing to fund extra government spending can have powerful effects on AD, output and employment when an economy is operating below full capacity output There is an automatic rise in the budget deficit to cushion the fall in AD caused by an external economic shock. A higher fiscal deficit is needed to lift AD back towards pre-recession levels If a fiscal stimulus works the budget deficit will improve as a result of higher tax revenues and reductions in welfare spending. A growing economy helps to shrink debt as a percentage of GDP It makes sense for a government to borrow money if interest rates are low and if the deficit is being used for investment

Is a High Level of Public Debt Dangerous? Public debt is the total accumulated stock of debt issued by a government yet to be re-paid – it is also known as the National Debt High deficits cause rising debt interest payments which in 2015-16 are are forecast to be £43 billion or £700 per head of population This interest burden has an opportunity cost for less interest on debt could free up extra spending on health and education. State borrowing of £70 billion is equivalent to £1,100 per head of the UK population An increase in the national debt is likely to cause higher taxes in the future. This will cut the disposable incomes of tax payers and reduce growth in the private sector It might be unfair if the rising tax burden falls more heavily on future generations of tax payers rather than people who benefit from government spending now. “A high level of government borrowing will result in money having to be spent repaying that debt. This can lead to both a reduction in investment and a requirement on future generations to continue paying off these debts, which could in turn have a negative impact on national well-being” ONS

Austerity – Is Cutting Government Spending Right? Is the Conservative Government right to continue following a policy of fiscal austerity in order to reduce the size of the budget deficit?

Austerity – Is Cutting Government Spending Right? Is the Conservative Government right to continue following a policy of fiscal austerity in order to reduce the size of the budget deficit? Arguments In Favour: Reducing debt in long run interests of economy – helps to keep UK taxes lower Shrinking state encourages private sector growth High opportunity cost from £billions on debt interest Cutting deficits increases investor confidence – attracts FDI into the UK Upturn of cycle is time for government to borrow less – ahead of another downturn Arguments Against: Austerity is self-defeating e.g. if it leads to deflation Government bond yields are low – a time to invest more Infrastructure investment will increase AD and LRAS Wrong to cut spending when economy is in liquidity trap Economic growth is needed to pay back the debt and fiscal austerity makes this harder to achieve

What is Crowding Out? The “crowding-out hypothesis” is an idea that became popular in the 1970s and 1980s when free-market economists argued against the rising share of GDP being taken by the public sector The crowding out view is that a rapid growth of government spending may cause a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower If the government runs a big budget deficit, it will have to sell debt to the private sector and getting individuals and institutions to purchase the debt may require higher interest rates. A rise in interest rates may then crowd-out private investment and consumption, offsetting the fiscal stimulus Eventually higher government spending needs to be funded by higher taxes and this again acts as a squeeze on spending and investment by the private sector of the economy. A fiscal stimulus is less effective in an expansion, because, at full capacity, an increase in public demand crowds out private demand, leaving output unchanged (with higher prices)

Crowding Out – Analysis Diagram Real Interest Rate Supply of loanable funds R2 R1 D2 (with government borrowing) Demand for loanable funds Increased government borrowing may lead to higher demand for loanable funds and a rise in market interest rates e.g. on bonds. This might increase borrowing costs for private sector businesses. Q1 Q2 Quantity of Loanable Funds

Evaluating the Crowding Out Theory The probability of 100% crowding-out is remote, especially if the economy is operating below its capacity and if there is a plentiful supply of saving available to purchase newly issued state debt Keynesian economists such as Paul Krugman argue that fiscal deficits crowd-in private sector investment. Well-targeted, timely and temporary increases in government spending can absorb under-utilized capacity and provide a strong multiplier effect that generates extra tax revenue. Another criticism of the basic theory is that the available supply of loanable funds is not limited to domestic sources, external finance is available from other countries

What is the Fiscal Multiplier? Fiscal multipliers measure the short-term impact of discretionary fiscal policy on national output The fiscal multiplier measures the effect of a £1 change in spending or a £1 change in tax revenue on the level of GDP According to an IMF research report published in 2014, “the literature finds that (government) spending multipliers tend to be larger than revenue multipliers.” This would be supported by Keynesian theory, which argues that tax cuts are less effective than spending increases in stimulating the economy since households may save a significant portion of the additional after-tax income. The IMF also found that fiscal multipliers are generally larger in downturns than in expansions – this supports the Keynesian view of using fiscal stimulus when conventional monetary policy is found to be ineffective

Summary of Factors Affecting Value of the Multiplier High Multiplier Value when Economy has plenty of spare capacity (i.e. a negative output gap) to meet higher aggregate demand Marginal propensity to import and tax is low – 2 important leakages) High propensity to consume any extra income (i.e. a low propensity to save) Low Multiplier Value when Economy is close to it’s capacity limits e.g. during a boom phase of the economic cycle Propensity to import goods & services is high – this means extra demand leaks from circular flow Higher inflation causes rising interest rates which then dampens the other components of AD What Determines the Size of the Fiscal Multiplier? Government capital investment—such as new infrastructure projects—often results in higher multiplier effects. Economists at the IMF have calculated the long-run multiplier value at +1.5 for developed countries and +1.6 for developing countries. Source: The Economist

What determines the size of the Fiscal Multiplier? Design: A key decision is whether to focus a fiscal stimulus on higher government spending, or perhaps a targeted tax reduction Financial stress: Uncertainty about job prospects, future income and inflation levels might make people save tax cuts Temporary or permanent fiscal raise: Expectations of the future drive behaviour today - most of us now expect taxes to rise in the coming years. Will this prompt a higher household saving and a paring back of spending and private sector borrowing? The availability of credit: If fiscal policy works in injecting fresh demand, we still need the banking system to supply sufficient credit to businesses who need to borrow to fund an increase in production Openness of the economy: The more open an economy is (i.e. the higher is the ratio of imports and exports to GDP) the greater the extent to which higher government spending or tax cuts will feed into rising demand for imports, lowering the impact on domestic GDP.

Fiscal Policy Economics – Some Key Terms Bond Yield The rate of interest paid on government debt Budget (Fiscal) Deficit The budget deficit is the difference between what the government receives in revenue and what it spends Cyclical Fiscal Deficit The size of the deficit is influenced by the state of the economy: in a boom, tax receipts are relatively high and spending on unemployment benefit is low Direct Taxation Taxes on income, profits and wealth, paid directly by the bearer to the tax authorities. Fiscal Policy Taxation and spending measures that allow the government to guide the economy. Indirect Taxation Taxes on expenditure (e.g. VAT). They are paid to the tax authorities, not by the consumer, but indirectly by the suppliers of the goods or services. National Debt Debt is the total amount owed by the government which has accumulated over the years. Structural Fiscal Deficit The structural deficit is that part of the deficit which is not related to the state of the economy. This part of the deficit will not disappear when the economy recovers.