Fiscal Policy Frederick University 2014

Fiscal policy A system of goals, tools and instruments to affect GDP and employment Subject – the Treasury (the Ministry of Finance) Goals:  Long run or short run  expansion or restriction  Discretion or rule-based policy  Fine tuning of the economy  Stabilization policy  structural policy Tools and instruments:  Government revenues  Government spending – government purchases and transfer payments

Government Budget Assessment of government revenues and expenditures, deficits and surpluses of government finance revenuesexpenditures Taxes G Transfer payments

Elementary Model of Fiscal Policy Through G Expansion – increase in G and in AD Restriction – decrease in G and reduction in AD Through Taxes expansion - reduction in T and increase in AD Restriction – increase in T and reduction in AD The taxation multiplier shows the change in GDP caused by a change in the tax rate taxation multiplier = - MPC/MPS

GDP gaps Price level GDP AD AS Y*Y1Y1 Y* - Y 1 = recessionary gap Price level GDP AD AS Y2Y2 Y* Y 2 – Y* = inflationary gap

Fiscal policy on the AE diagram AE Y 45 o AE 1 AE 2 Y1Y1 Y2Y2 Expansionary fiscal policy – G increases and AE rise, as a result, Y rises

Budget deficit (surplus) and government debt Budget deficit (surplus):  Primary deficit (surplus) = current revenues-current expenditures  Secondary deficit (surplus) = primary deficit (surplus) + interest payments on domestic debt  Cash deficit (surplus) = secondary deficit (surplus) + flows of external revenues and payments Cyclical vs. structural deficit (surplus) Government debt

Effectiveness of the Fiscal Policy Discretionary vs. Rule-based policy Built-in stabilizers:  in the budget – income taxes, corporate taxes, social payments  in the economy – excess capacity, purchases of foreign goods, corporate dividend policy, autonomous spending Crowding-out and crowding-in effect Time lags

Supply-side Fiscal Policy A system of goals, tools and instruments to affect aggregate supply Goals: Increase in productivity Reduction of the inflationary pressure Reduction in the need for government spending Reduction of government debt Reduction of the crowding-out effect Effectiveness - Depends on the elasticity of factor supply factor payments and disposable income

Laffer Curve Т t 0 100%

Discussions on the effectiveness of fiscal policy Different time horizons and different assessment of the: Stability of the macroeconomic equilibrium Elasticity of investment demand as regard the interest rate Expectations – adaptive vs. rational Dynamics of the aggregate supply