1. Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by

2. 13-2 © 2016 McGraw ‐ Hill Education Limited LEARNING OBJECTIVES LO13.1Identify and explain the purposes, tools, and limitations of fiscal policy. LO13.2Explain the role of built-in stabilizers in moderating business cycles. LO13.3Describe how the cyclically adjusted budget reveals the status of Canadian fiscal policy. LO13.4Summarize recent Canadian fiscal policy and the projections for Canadian fiscal policy over the next few years. LO13.5Discuss the problems that governments may encounter in enacting and applying fiscal policy. LO13.6Discuss the size, composition, and consequences of the Canadian public debt. 13 Fiscal Policy, Deficits, Surpluses, and Debt

3. Since 1945, fiscal policy has been one of the government’s main stabilization policy tools “active” if changes in government spending or taxes are at the option of the government “non-discretionary” if independent of parliamentary action LO1 © 2016 McGraw ‐ Hill Education Limited 13.1 Fiscal Policy and the AD-AS Model 13-3

4. Expansionary Fiscal Policy Used when Recession Occurs Options: Increased Government Spending Tax Reductions Combined Government Spending Increases and Tax Reductions  May Create a Budget Deficit LO1 © 2016 McGraw ‐ Hill Education Limited 13.1 Fiscal Policy and the AD-AS Model 13-4

5. © 2016 McGraw ‐ Hill Education Limited LO1 13-5 FIGURE 13-1 Expansionary Fiscal Policy Real GDP (billions) Price level AD 2 AD 1 $5 billion increase in spending Full $20 billion increase in aggregate demand AS $490$510 P1P1 Recessions Decrease AD

6. Contractionary Fiscal Policy Used to Combat Demand-pull Inflation Options: Decreased Government Spending Increased Taxes Combined Government Spending Decreases and Tax Increases LO1 © 2016 McGraw ‐ Hill Education Limited 13.1 Fiscal Policy and the AD-AS Model 13-6

7. © 2016 McGraw ‐ Hill Education Limited LO1 13-7 FIGURE 13-2 Contractionary Fiscal Policy Real GDP (billions) Price level AD 3 AD 4 $3 billion initial decrease in spending Full $12 billion decrease in aggregate demand AS $502 $ 522 P2P2 AD 5 $ 510 d b a P1P1 c

8. Policy Options: G or T? To expand the size of government If recession, then increase government spending If inflation, then increase taxes To reduce the size of government If recession, then decrease taxes If inflation, then decrease government spending LO1 © 2016 McGraw ‐ Hill Education Limited 13.1 Fiscal Policy and the AD-AS Model 13-8

9. Net tax revenues vary directly with GDP Taxes rise when GDP rises, and vice versa Transfer payments fall when GDP rises, and vice versa Leads to automatic stabilization over the business cycle. LO2 © 2016 McGraw ‐ Hill Education Limited 13.2 Built-in Stability 13-9

10. Automatic or Built-In Stabilizers A structure of taxation and spending that: Increases the deficit (reduces the surplus) during recession Increases the surplus (reduces the deficit) during inflation LO2 © 2016 McGraw ‐ Hill Education Limited 13.2 Built-in Stability 13-10

11. ECONOMIC IMPORTANCE The stabilizers will automatically restrain economic expansion and cushion economic contraction. Taxes reduce spending and aggregate demand. Reductions in spending are desirable when the economy is developing inflationary pressures. Increases in spending are desirable when the economy is slumping. LO2 © 2016 McGraw ‐ Hill Education Limited 13.2 Built-in Stability 13-11

12. © 2016 McGraw ‐ Hill Education Limited LO2 13-12 FIGURE 13-3 Built-in Stability G T Deficit Surplus GDP 1 GDP 2 GDP 3 Government expenditures, G, and tax revenues, T Real domestic output, GDP

13. TAX PROGRESSIVITY The built-in stability depends on: Tax Progressivity Progressive Proportional Regressive The more progressive the tax system, the greater the economy’s built-in stability LO2 © 2016 McGraw ‐ Hill Education Limited 13.2 Built-in Stability 13-13

14. To evaluate fiscal policy stance, must Adjust deficits and surpluses to eliminate automatic changes in tax revenues Compare adjusted budgets to GDP LO3 © 2016 McGraw ‐ Hill Education Limited 13.3 Evaluating How Expansionary or Contractionary Fiscal Policy Is Determined 13-14

15. Cyclically Adjusted Budget The cyclically adjusted budget shows what the budget balance would be if the economy were operating at full employment. LO3 © 2016 McGraw ‐ Hill Education Limited 13.3 Evaluating How Expansionary or Contractionary Fiscal Policy Is Determined 13-15

16. © 2016 McGraw ‐ Hill Education Limited LO3 13-16 FIGURE 13-4 Cyclically Adjusted Deficits G T GDP 2 GDP 1 Real domestic output, GDP Government expenditures, G, and tax revenues, T (billions) (year 2)(year 1) $500 450 a b c

17. © 2016 McGraw ‐ Hill Education Limited LO3 13-17 FIGURE 13-4 Cyclically Adjusted Deficits G T1T1 GDP 4 GDP 3 Real domestic output, GDP Government expenditures, G, and tax revenues, T (billions) (year 4)(year 3) $500 450 d e f 475 425 g T2T2 h

18. Neutral to mildly expansionary in the early 1990s Contractionary in late 1990s Between 1995 and 2007, actual deficits have given way to actual surpluses In 2008, “Canada’s Economic Action Plan” and the federal budget moved quickly to a deficit In 2009, expansionary fiscal policy LO4 © 2016 McGraw ‐ Hill Education Limited 13.4 Recent Canadian Fiscal Policy 13-18

19. © 2016 McGraw ‐ Hill Education Limited LO4 13-19 TABLE 13-1 Federal Deficits (-) and Surpluses (+) as Percentage of GDP, 2000-2013 (1) Year(2) Actual deficit or surplus(3) Cyclically adjusted deficit or surplus 2000+1.4+1.8 2001+1.9+1.1 2002+0.7+0.8 2003+0.6+1.2 2004+0.7+0.9 2005+0.1+0.9 2006+0.9 2007+0.9+0.5 2008+0.60.0 2009-0.3-0.2 2010-3.4-0.8 2011-1.9-0.6 2012-1.5-0.9 2013-0.8 Source: Department of Finance Canada, 2013

20. 13.1 GLOBAL PERSPECTIVE Cyclically Adjusted Budget Deficits and Surpluses as a Percentage of Potential GDP, Selected Nations © 2016 McGraw ‐ Hill Education Limited LO4 13-20

21. Problems of Timing Recognition Lag Administration Lag Operational Lag Political Considerations Future Policy Reversals Offsetting Provincial and Municipal Finance LO5 © 2016 McGraw ‐ Hill Education Limited 13.5 Problems, Criticisms, and Complications of Implementing Fiscal Policy 13-21

22. Crowding-Out Effect Expansionary fiscal policy may lead to higher interest rates reduction in interest-sensitive spending May not be significant in a recession Fiscal policy can be accommodated by increases in money supply LO5 © 2016 McGraw ‐ Hill Education Limited 13.5 Problems, Criticisms, and Complications of Implementing Fiscal Policy 13-22

23. © 2016 McGraw ‐ Hill Education Limited LO5 13-23 FIGURE 13-5 Fiscal Policy: The Effects of Crowding Out and the Net Export Effect Real domestic output, GDP Price level AD 0 AS P0P0 P1P1 GDP GDP 1 GDP f AD 1 c a b 0 AD’ 1 With an upward-sloping aggregate supply curve, a part of the impact of an expansionary policy will be reflected in a rise in the price level rather than an increase in real output and employment.

24. Fiscal Policy in the Open Economy SHOCKS ORIGINATING FROM ABROAD Economies are open to unforeseen international aggregate demand shocks e.g. Canadian Economy was affected by the turmoil in the US housing and financial markets NET EXPORT EFFECT LO5 © 2016 McGraw ‐ Hill Education Limited 13.5 Problems, Criticisms, and Complications of Implementing Fiscal Policy 13-24

25. © 2016 McGraw ‐ Hill Education Limited LO5 13-25 TABLE 13-2Fiscal Policy and the Net Export Effect

26. Current Thinking on Fiscal Policy Most economists believe fiscal policy is a useful policy lever not for “fine-tuning” major discretionary fiscal policy should be held in reserve should be evaluated for impact on long-run productivity growth LO5 © 2016 McGraw ‐ Hill Education Limited 13.5 Problems, Criticisms, and Complications of Implementing Fiscal Policy 13-26

27. Budget Surplus Annual amount by which government revenues exceed government expenditures Budget Deficit Annual amount by which government expenditures exceed taxes Public Debt Accumulation of all past deficits and surpluses LO6 © 2016 McGraw ‐ Hill Education Limited 13.6 Deficits, Surpluses, and the Federal Debt 13-27

28. Debt and GDP Relative size of the debt fell in the last decade but rose after 2009 Great Recession again. International Comparisons Our debt is among lowest as % of GDP among world’s industrialized nations Interest Charges The primary burden of the debt is the annual interest charge Ownership About 80% of the total debt is held internally and about 20% of the gross federal debt is held by foreigners. LO6 © 2016 McGraw ‐ Hill Education Limited 13.6 Deficits, Surpluses, and the Federal Debt 13-28

29. © 2016 McGraw ‐ Hill Education Limited LO6 13-29 FIGURE 13-6 The Gross Federal Debt as a Percentage of GDP

30. 13.2 GLOBAL PERSPECTIVE Publicly Held Debt: International Comparisons © 2016 McGraw ‐ Hill Education Limited LO6 13-30

31. © 2016 McGraw ‐ Hill Education Limited LO6 13-31 FIGURE 13-7 Ownership of Canada’s Gross Public Debt in 2011 Source: Adapted from Bank of Canada, Banking and Financial Statistics, April 2015. http://www.bankofcanada.ca/wp- content/uploads/2015/04/bfs_april15.pdf, accessed May 27, 2015, and the Department of Finance, Fiscal Reference Tables http://www.fin.gc.ca/afr-rfa/2014/report-rapport-eng.asp#toc5, accessed May 27, 2015.http://www.bankofcanada.ca/wp- content/uploads/2015/04/bfs_april15.pdf http://www.fin.gc.ca/afr-rfa/2014/report-rapport-eng.asp#toc5

32. Unfounded Concerns BANKRUPTCY Refinancing Taxation BURDENING FUTURE GENERATIONS Canada owes a substantial portion of the public debt to itself LO6 © 2016 McGraw ‐ Hill Education Limited 13-32 13.6 Deficits, Surpluses, and the Federal Debt

33. Substantive Issues INCOME DISTRIBUTION INCENTIVES FOREIGN-OWNED PUBLIC DEBT CROWDING OUT REVISITED Public Investments and Public-Private Complementarities LO6 © 2016 McGraw ‐ Hill Education Limited 13-33 13.6 Deficits, Surpluses, and the Federal Debt

34. © 2016 McGraw ‐ Hill Education Limited LO6 13-34 FIGURE 13-8 The Investment Demand Curve and the Crowding- Out Effect 5101520253035400 2 4 6 8 10 12 14 16 Real interest rate (percent) Investment (billions of dollars) ID 1 ID 2 a bc Increase in investment demand Crowding-out effect

35. The LAST WORD Federal and Provincial per Capita Net Debt, 2014 © 2016 McGraw ‐ Hill Education Limited 13-35 Canada$ 17,985 Quebec 19,924 Newfoundland and Labrador 16,094 Ontario 16,040 Nova Scotia 13,573 New Brunswick 12,748 Prince Edward Island 11,788 Manitoba 10,631 British Columbia 6.699 Saskatchewan 3,474 Alberta -4,868 Source: Statistics Canada and the Department of Finance, 2011

36. LO13.1 Identify and explain the purposes, tools, and limitations of fiscal policy. LO13.2 Explain the role of built-in stabilizers in moderating business cycles. LO13.3 Describe how the cyclically adjusted budget reveals the status of Canadian fiscal policy. LO13.4 Summarize recent Canadian fiscal policy and the projections for Canadian fiscal policy over the next few years. LO13.5 Discuss the problems that governments may encounter in enacting and applying fiscal policy. LO13.6 Discuss the size, composition, and consequences of the Canadian public debt. Chapter Summary © 2016 McGraw ‐ Hill Education Limited 13-36