Chapter 11 Fiscal policy

Discretionary Fiscal Policy?

- Deliberate changes in tax revenue or government spending to stabilize the economy. Types: -Contractionary fiscal policy -Expansionary fiscal policy

government spending rises by $100 bil government funds by a tax increase of $100 bil what is this called and what will happen to real gdp and why

-"balanced budget" -cause equilibrium real gdp to rise -the reason this is because government spending increases aggregate spending directly. However, taxes effect aggregate spending indirectly. This means that when taxes $100, person will reduce spending by $90 (not an even $100).

Changing LRAS with fiscal policy:

-Encouraging research and development, investment in education and technology. -improved technology and increase in productivity can expand LRAS

What is Expansionary Fiscal Policy?

-INCREASE in Government Spending -DECREASE in taxes -A combination of both. It is designed to expand the economy. Shift to the Right=Increase in AD

Contractionary fiscal policy?

-Required in demand-pull inflation -Need to decrease AD -Decrease in government spending or increase in taxes

Expansionary Fiscal Policy

-Unemployment goes up Increase -required in recession -need to increase AD -Increase in government spending or decrease in taxes

government increase in taxes government increases in spending

-both raise spending in the economy -$1 spent government/reduced taxes, has multiplied effect in the economy... worth more than $1

two different types of taxes -direct -indirect

-direct taxes- on individuals and firms -indirect taxes-on goods and services (easier to collect and therefore more important to developing countries)

what is a main difference between developed countries and developing countries

-government plays a larger role in investment spending in developing countries. (need roads, schools, hospitals) -

Supply-side fiscal policy

-is found to be found less effective -take much longer than demand-side policies to be effective.

what are the effects of the budget deficit?

-some lenders will have to have higher interest rates to induce them to hold more government debt in return depress investments -can effect international trade. the demand for us dollar will be more desirable to foreign countries. This will cause the us dollar to appreciate. this will cause more usa people to buy foreign goods. -the debt the government owns has interest which will have to be paid as well. However, this is offset because it is the us people who get the interest back. However, many are held by foreign people which does not benefit the us people. -overall the effects on investment, deficits can lower the level of output in the economy.

How has austerity vindicated macroeconomics?

1) Austerity has moderated/delayed/prevented recovery from the recession. 2) Rising debt has not let to rising interest rates on debt. 3) QE has not led to inflation. Yet mainstream macro has been largely ignored by policy makers, leading to huge welfare losses.

Why not ban government deficits - or more specifically, why can't debt to gap ratio rise?

1) Automatic stabilisers - in a recession taxes automatically fall and some spending rises (e.g. benefits), and to reverse this would add to any demand problem. 2) Discretionary action - particularly if monetary policy is constrained (e.g. ZLB). 3) Sometimes future generations should pay for future benefits of spending today - e.g. wars. 4) Tax smoothing. What matters to welfare is taxes and spending, not debt. If marginal costs of taxes increases with the level of taxes, then fiscal instruments should be smoothed

Causes of deficit bias

1) Exploiting future generations. Debt allows the current generation to take resources from future generations. 2) Impatience (e.g. politicians discount too heavily because they may be voted out of office (they discount at a higher rate than electorate); or on party of electorate). If we take the first case as the important one, we need a reason why electorate cannot discipline impatient politicians by voting them out (e.g. fiscal policy only one dimension of election). 3) Common Pool problem. Benefits of any spending/tax cut are concentrated, whereas cost is spread more widely. Those groups lobby for these with insufficient regard to the full budgetary costs now as well as in the future. 4) Inadequate information eg forecasts too optimistic, government accounts opaque. Over-optimism about future growth can lead to deficit bias because future tax revenues will not be as high as is hoped. 5*) Electoral competition. Governments do not fully internalise the cost of debt because those costs may be borne by opposing party if government is not re-elected. Increase debt to constrain actions of future government with different political preferences

Why does high and/or rising debt matter, if inter temporal budget constraint IS NOT satisfied by fiscal action

1) Government default. Forced or government choice because high taxes/low spending too unpopular. 2) Inflation - An alternative to debt financing is money finance. In a recession this may be helpful, but too much money in medium to long term can increase inflation. Wren Lewis (2010) - The key limit is not when a government will probably default, but when the possibility that it will default becomes significant enough for lenders to require a risk premium to offset this chance.

Can fiscal policy council solve causes of deficit bias?

1) If it results from informational problems such as over optimism in forecasts - problem solved by independent forecasting institution like OBR 2) Militate against government impatience. Fiscal policy design and implementation delegation prevents politically-motivated fiscal policy which results in ever increasing deficit 3) Common Pool Problem. Groups lobby for fiscal benefits without due regard to budgetary costs now and in future. Recommendations from fiscal council could strengthen finance minister in negotiations

When is monetary policy not enough?

1) In a fixed exchange rate regime or monetary union. 2) If nominal interest rates hit their Zero Lower Bound. But is the ZLB problem real? 1) Unconventional monetary policy! EG QE which seems to have some positive effects, but its impact may be finite. Its also a very uncertain instrument which makes it a poor substitute for conventional mon pol or counter cyclical fiscal pol. 2) The ZLB could be reduced by a move to price level or nominal GDP targets. However no CB tried this and macro analysis suggests still role for fiscal policy with these new forms of mon pol.

How can current generation exploit future generations?

1) More spending and tax cuts now, paid for by raising debt, where the future generations pay at least the interest on that debt. This happens because generations overlap. If generations didn't overlap this couldn't happen. 2) The young pay the old directly through unfunded social security systems - National Insurance. Exploits future generations if scheme is wound up, or if implicit return to forced saving is less than return to private saving. 3) Rising prices for an asset the old own and young need to buy: housing 4) Creating problems for future generations to deal with: climate change.

Problems with fiscal councils

1) Multitude of instruments - lack of consensus about which to use in a given scenario 2) The optimal level of debt and deficit, the presumable targets of an independent fiscal authority, are questions about how much future generations should pay for present consumption. Normative questions that belong in political rather than economic realm?

Methods of financing government spending

1) Taxation 2) Borrowing from public (bond issuing) 3) Borrowing from CB (New money creation)

Issues when setting up a fiscal council in practice

1) What would be its remit? Should a fiscal council act both as a policeman for the intermediate targets set by the government and as a judge of the appropriateness of these targets. 2) Indepednence? Another risk derives from the fact that, especially in a small county - almost - everybody in a field such as economic policy analysis knows each other. Psychological bias to be "too kind".

what are the two components of fiscal policy

1. discretionary fiscal policy 2. automatic stabilizers

what are two kinds of automatic stabilizers

1. progressive tax- a tax whose rate rises as income rises (this helps to offset the effects of lower income on spending) -transfer payments- a payment to one person that is funded by taxing others (food stamps, welfare benefits, unemployment benefits).

Demand-side fiscal policy?

= Stimulating AD Types: Discretionary fiscal policy and Automatic stabilizer

Supply-side fiscal policy?

=Stimulating AS

Problems with expansionary fiscal policy: crowding out

=decrease in private expenditures as a result of - potential only: -increased government spending - government spending increases -increase in government borrowing -increase in interest rates -decrease in consumptions and investment -Due to crowding out, expansionary fiscal policy could be less successful.

Fiscal consolidation strategies

A term used to refer the implementation of fiscal policy so as to achieve a sustainable debt ratio. Fiscal consolidation typically reduces output and raises unemployment in the short term. Gradualist policy requires frequent readjustment of the fiscal stance to ease the economy toward the long-run sustainable position. After the shock is over, we can think of two choices. The first is to accommodate the rise in debt: raise taxes (or cut spending) by just enough to finance interest payments on the higher stock of debt. This results in a permanent distortion (taxes are permanently higher), but the discounted value of this distortion is finite. The second choice is to raise taxes (or cut spending) by much more, to bring debt back to its original level. We can call this 'debt targeting'. This has much higher costs in the short term, but these costs are temporary. So as long as debt was not attracting a significant risk premium, its reduction should be slow, and is likely to be erratic as further shocks hit the economy. It would be a mistake to adopt D* as an explicit 'debt target', even if we knew what D* was. Macroeconomic targets are useful when there is a chance that the target might be hit within the lifetime of a government or government agency, and when failure to meet that target represents a policy failure.

Long run debt sustainability

Assuming b > 0 (ie positive government debt) Since ∆b = d + (r - g).b Then for ∆b ≤ 0 • b ≤ -d/ ( r - g ) Which says that for long-run sustainability, with a given long-run real interest rate in excess of the expected long-run growth rate, there must be a long-run primary surplus if the debt ratio is to be constant.

What is an Automatic Stabilizer? (Nondiscretionary Fiscal Policy)

Automatic changes in federal expenditures and tax revenue. (Stabilizes the "ups and downs") (A federal expenditure or tax revenue that automatically changes levels in order to stabilize an economic expansion/contraction. (Nondiscretionary Fiscal Policy)

Blurring the lines between fiscal and monetary policy

Borrowing subsidies such as Funding for Lending and Help to Buy.

Why does high and/or rising debt matter, if inter temporal budget constraint still satisfied by fiscal action

Case where government always pays back its borrowing, never defaults, never allows runaway inflation. 1) Crowding out. Government debt crowds out productive capital in long run, implying higher interest rates and therefore lower output (unless Ricardian Equivalence holds). 2) Intergenerational redistribution. Future generations pay higher taxes or suffer lack of public goods. 3) Distortions. Government debt requires higher taxes to finance it, and if these taxes are distortionary, this reduces output and consumption. Concerns are all medium to long term concerns - this is important.

Automatic Stabilizer

Change in tax revenue or governments spending without any deliberate policy changes by government -e.g. progressive income tax(more income more taxes you have), unemployment compensation

Herndon, Ash and Pollin (2013) - Does high public debt consistently stifle economic growth? A criqtiue of Reinhart and Rogoff.

Contrary to Reinhart and Rogoff's broader contentions, both mean and median GDP growth when public debt levels exceed 90% of GDP are not dramatically different from when the public debt/GDP ratios are lower. More generally, contrary to RR, we find no evidence for a dramatic drop-off in average GDP growth when countries' public debt levels rise above 90% of their GDP. We correspondingly refute the claim by RR that there exists a 'historical boundary' that is robust across countries and time periods in which economic growth consistently falls off in a non-linear pattern when the public debt levels exceed 90% of GDP. Over 1946-2009, countries with public debt/GDP ratios above 90% averaged 2.2% real annual GDP growth, not −0.1% as published.

Deficit Bias vs Inflation Bias

Costs: Cost of deficit bias in the future, cost of inflation bias is today. Outcomes: Increase output and employment today in exchange for cost. Similar causes: 1) Discounting of future too heavily because of possibility of being voted out

Sustainability of Government Debt

Debt to GDP not rising in the long term

UK Debt empirics

Debt to GDP ratio not a problem before recession. The reasons why UK debt is so high today is not fiscal excess before 2007, but: 1) mainly the fact that the recession appears to have led to a permanent fall in UK GDP and 2) and to a small extent the use of fiscal policy to support the economy at the start of the recession.

Is there a tendency to 'deficit bias'?

Deficit Bias - the tendency for government debt as a share of GDP to increase over time. Average OECD debt to GDP ratio roughly doubled in 30 years before 2007. Note that deficit bias not so clear in the UK or US. Calmfors and Wren-Lewis 2011- Between the mid 1970s and the mid 1990s. During this period, the gross debt ratio nearly doubled in the OECD, rising from around 40 per cent of GDP to about 75 per cent. Developments were surprisingly similar in Europe, the US and Japan. These developments gave rise to a large literature on deficit bias

Problems with fiscal policy: time

Discretionary fiscal policy to be effective. -time to approve policies -time to implement

Taxes Rise vs Gov spending cut for fiscal contraction?

Fiscal consolidation via higher taxes is likely to raise equilbiirum unemployment PS curve shifts town and lead to monetary tightening under inflation targeting central bank. By contrast, a consolidation based on cuts in public sector pay or employment or in benefits is likely to lower equilbiirum unemployment (WS curve shifts downwards) and permits an easing of monetary policy. IMF - Consolidation is more painful when it relies primarily on tax hikes; this occurs largely because central banks typically provide ess monetary stimulus during such episodes. Also, fiscal consolidation is more costly when the perceived risk of sovereign default is low. o Spending-based adjustments are less contraction- ary than tax-based adjustments. In the case of tax-based programs, the effect of a fiscal con- solidation of 1 percent of GDP on GDP is -1.3 percent after two years (Figure 3.5). In the case of spending-based programs, the effect is -0.3 percent after two years, and is not statistically significant - ***Much of the difference is due to the response of monetary conditions to fiscal consolidation: interest rates and the value of the currency tend to fall more following spending-based consolidation.*** These findings are in line with the notion that central banks view spending-based deficit cuts more favorably, possibly because they interpret them as a signal of a stronger commitment to fiscal discipline

The limits to fiscal stimulus - Buiter - 2009

For a fiscal stimulus to be both effective there must be idle resources due to a failure of effective demand. For it to be desirable, there must be no alternative policy instruments (including monetary policy) for boosting demand. Expansionary fiscal policy must not drive up interest rates, either by raising the risk-free real interest rate or by raising the sovereign default risk premium, to such an extent that the fiscal stimulus is emasculated through financial crowding out. Fourth, at given interest rates, the expansionary fiscal policy measures must not be neutralized by direct crowding out (the displacement of private spending by public spending or of public dissaving by private saving at given present and future interest rates, prices, and activity levels). Finally, for international coordination to be desirable, there must be cross-border externalities from national fiscal stimuli.

Government budget identity

G + iB = T + ∆B + ∆H Gov exp + interest = tax revenue + new bonds + new money

Seignorage and money creation.

General for of the government's budget identity: G + iB = T + ∆B + ∆H Where ∆H is new high-powered money. Thus ∆b = d + (r-g)b - µh Where µ is the growth rate of high-powered money. We can clearly see that the growth of the debt to GDP ratio is reduce by the extent to which the deficit is being financed by new money creation Growth rate of money supply is equal to the rate of inflation assuming the banking multiplier κ is constant. This has led to the use of the term inflation tax to refer to this method of financing government expenditure. Limit to which seignorage can be used as revenue source. Because, as inflation goes up, public becomes less willing to hold money. Empirical studies suggest that when inflation rates of higher than 200% pa seigniorage ceases to be an effective revenue generation mechanism because the demand for money falls so much. This suggests the max amount of revenue gov could raise this way would be about 10%.

Why use monetary policy rather than fiscal policy for short-term stabilisation?

Generally in economies with flex exchange rates, monetary policy rather than fiscal policy used to stabilise. Why?: 1) Fiscal instruments less easy to change (implementation lags). 2) Some fiscal instruments may have small impact (Ricardian Equivalence) 3) Moving fiscal instruments has allocation costs (taxes are distortionary, utility from public goods). 4) May distract governments from controlling deficits? (leads to deficit bias) 5) Using monetary policy is natural if goal is flex-price coutnerfactural. If youre a New-Keynesian, then in a recession you think 'what relative price is wrong?' Macro-economist can do the same thing, the price thats wrong is the interest rate! Obvious way to solve is through monetary policy. 1st and 4th arguments do not apply to automatic stabilisers.

Money financed fiscal expansion

Gov sells bonds to CB and spends the newly printed money on it expenditure initiative. Medium run consequences: 1) Monetary policy cannot both provide a nominal anchor and be used at will to financeexpenditure

Debt and distortionary taxes

Higher debt requires higher taxes (or lower spending on public goods) to pay the interest. But if all government debt is owned domestically, there is no negative income effect in aggregate (but future generations are worse off if debt rises). However if taxes are distortionary, this has negative incentive effects. Problem, to deal with long run problem of higher distortionary taxes paying of debt, government has to raise distortionary taxes now!

Hyper inflation

Inflation about 50% per month

Changing attitudes during recession.

Initially (2009), many voices argued for countercyclical fiscal policy (UK, US, IMF). Action in UK, US, Germany etc. After Greek crisis in 2010, consensus moved toward austerity and against further stimulus. IMF is a prime example of this. Reason for the turn to austerity in 2010: 1) Political! Many on the right opposed fiscal stimulus in 2009. Reducing the deficit is a useful pretext for reducing the size of the state. Most austerity in the form of spending cuts, not tax increases (UK, over 905). 2) Eurozone panic. Recent IMF evaluation. Policy makers were misled by the Eurozone crisis. IMF now recognise they were wrong to recommend austerity in 2010. They did this because of fears regarding eurozone crisis.

Changing SRAS with fiscal policy

Lower tax rates provide incentive: -to work more -to invest more. increase in investment, increases in production =INCREASE IN SRAS

Open economy considerations

Mundell Fleming says that fiscal policy ineffective under flexible exchange rates, but such a model is wrong. Assumes a fixed money supply, does not use UIP. If real interest rates fixed, UIP says real exchange rate unchanged as a result of temporary change in G or T. So logic of closed economy applies. If monetary policy chooses to counteract fiscal policy then effects mitigated.

Crowding Out - Does government debt crowd out capital?

Not if higher debt leads to an equal rise in private savings. Ricardian Equivalence: government debt implies future tax increases, so savings rise to pay for these. Can't believe in crowding out and Ricardian Equivalence at the same time - not logical. If saving does not rise by enough, because, for example, agents do not allow for higher taxes their children will pay when leaving bequests. In this case long run crowding out will occur to some degree. A lower capital stock will be accompanied by higher real interest rates. The extent of crowding out could be large if: 1) Saving is largely to fund spending in retirement. 2) This saving is not very sensitive to movements in interest rates. Types of crowding out***: 1) Financial Crowding Out - Occurs through the response of interest rates, the exchange rate, and other asset prices to fiscal actions. 2) Real resource crowding out - when real resource constraints (capital and labour bottlenecks) limit output expansion). In an open economy, the domestic supply constraint on final demand can be relaxed through the trade balance. For the world as a whole this is not possible.

Closed Economy considerations

Temporary cut in government spending will reduce output even if Ricardian equivalence holds. Spending happens now, but (explicit or implicit) tax increases are smoothed. If Ricardian Equivalence does not hold, debt financed tax cuts will also increase demand. Other taxes may bring forward private sector spending (e.g. UK 2008 temporary VAT cut). All this assumes no deliberate monetary policy offset. If monetary policy is unconstrained, can in theory offset any fiscal action.

as income falls as income rises what does automatic stabilizers do

as income falls automatic stabilizers-increase spending as income rises automatic stabilizers-decrease spending

historically the growth of government spending has been matched by growth of ______. since the 1960 government spending began to grow faster than _________.

both revenue

how does the government borrow funds?

by selling bonds to the public (bonds are debt that must be repaid at a further point. It is a substitute for taxes. The government borrows the savings of businesses and households. Downside is that taxes will have to become higher for government to pay off borrowed money.)

What is fiscal policy?

changes in federal government purchases, transfer payments and or taxes to influence the economic policy. - it is reflected in federal government budget.

discretionary fiscal policy

changes in government spending and taxation that are aimed at achieving policy goal

how is government spending financed (equation)

como of taxes, borrow and creating money government spending=taxes+changes in government debt + changes in government-issued money.

increased government spending can reduce

consumption and investment spending

taxes on international trade are really important to

developing countries.

what is the main thing that the standard multiplier analysis of government spending does not differentiate among the what

different methods of how the financing government spending (borrow/taxes)

the the government increases spending it effects investments by

driving up interest rates. when interest rates go up investments fall.

besides war time when do budget deficits increase the most?

during a recession when real gdp falls, tax revenue falls, government spending on unemployment and welfare go up.

a major implication of large deficit is the result of

increase in national debt (total stock of government bonds)

how does taxes alter spending

indirectly by effecting how households consume

How does the government try to close the gdp gap between potential and actual gdp?

it must use fiscal policy to alter expenditures and cause aggregate demand curve to shift -is government's policy with respect to taxes and spending (government spending is a part of real gdp and directly effects aggregate demand. )

What do Automatic Stabilizer do?

reduce the intensity of business fluctuations.

an increase in government spending shifts the aggregate demand curve to the _____ if higher taxes reduces the incenetive to work, aggregate supply would______

right shift up (less output) this would be a level bellow potential real gdp

government spending and taxes ____ the demand curve

shift (demand curve=equilibrium curve that shows aggregate spending at different alternative prices)

the difference between revenue and government spending is either

surplus or deficit budget

Ricardian Equivalence holds if

taxation and government borrowing both have the same effect on spending in the private sector. **is the principle that government spending activities financed by taxation and those financed by borrowing have the same effect on the economy.

why have deficient become a common thing in government

the federal budget is determined by as much politics as economics. Different politicians respond to different government program without considering fiscal policy. It is political response that tends to drive up budget deficits

what happens if price level rises as real gdp prices

the multiplier effects of any given change in aggregate demand are smaller than they would be if the price level remained constant

the standard analysis of government spending and taxes assume that aggregate supply is not effected by changes in fisical policy. the problem with this?

this makes us think that there will be great changes in real gdp than actually may occur. we don't know the extent of this effect

Austerity vs Stimulus: an intertemporal problem.

Suppose we believe countercyclical fiscal policy is necessary at LB, but we also think high debt levels are damaging in longer term. Explaining the above - in 2009, recession seemed like bigger problem. In 2010, government debt seemed like bigger problem. Is there a dilemma? In principle no. The need for countercyclical policy is (by definition) short term, but the problems of government debt are long term. So stimulus today, and austerity tomorrow! Focus on the debt problem when interest rates have begun to rise because then monetary policy can offset fiscal retrenchment!!!

Reinhart and Rogoff (2010) - Growth in a time of debt.

Our main result is that whereas the link between growth and debt seems relatively weak at "nor- mal" debt levels, median growth rates for coun- tries with public debt over roughly 90 percent of GDP are about one percent lower than other- wise. Sharply rising interest rates, in turn, force painful fiscal adjustment in the form of tax hikes and spending cuts, or, in some cases, outright default.As countries hit debt tolerance ceilings, market interest rates can begin to rise quite sud- denly, forcing painful adjustment. It is evident that there is no obvious link between debt and growth until pubic debt reaches a threshold of 90%. Over the past two centuries, debt in excess of 90 percent has typically been associated with mean growth of 1.7 percent versus 3.7 percent when debt is low (under 30 percent of GDP), and compared with growth rates of over 3 percent for the two middle categories (debt between 30 and 90 per- cent of GDP). Of course, there is considerable variation across the countries, with some coun- tries such as Australia and New Zealand experi- encing no growth deterioration at very high debt levels. For emerging economies - o For 1900-2009, for example, median and aver- age GDP growth hovers around 4-4.5 percent for levels of debt below 90 percent of GDP, but median growth falls markedly to 2.9 percent for high debt (above 90 percent); the decline is even greater for the average growth rate, which falls to 1 percent.

Simon Wren-Lewis - 2011 - The Case Against Austerity Today

Outside of the eurozone, the problem is that we have too little government debt, rather than too much. There is a straightforward reason why the current debt crisis is largely confined to the euro area, which can be summed up in one short statement: these countries cannot print their own currency. • As De Grauwe (2011) points out, eurozone governments can be subject to the equivalent of a bank run. If no one buys their debt, they will be forced to default. Lenders may decline to buy their debt because they believe that ultimately those governments do not have the political will to raise the taxes to cover their spending in a sustainable way: this is the equivalent of an insolvent bank. Both Keynesian macroeconomics as taught to first-year undergraduates and the state of the art Keynesian macroeconomics used by central banks tell us that the optimal response to the twin problems of deficient demand in the short run and excessive debt in the long run is a fiscal stimulus today followed by austerity when the recovery is assured. Governments are subject to 'deficit bias': the tendency for government debt as a share of GDP to drift up over time. Evidence over the last 40 years (but perhaps not over a much longer time frame) is consistent with deficit bias (Calmfors and Wren-Lewis 2011). There is a good economic case for arguing that, over the long term, government debt in relation to GDP should be a lot lower than levels seen before the start of the recession. The incorrect inference is that this means that the process of reducing debt has to be unconditional and rapid. Once again, all the macroeconomic analysis (Keynesian or otherwise) suggests the opposite: debt should be allowed to respond to macroeconomic shocks, and debt correction should be gradual and context sensitive (Wren-Lewis 2011). A simple analogy has some power here. If someone is overweight, what would you be more impressed by: a person who analyses why they are overweight, and embarks on a long-term plan (with suitable checks) to correct the problem, or someone who goes on a crash diet?

Prudent fiscal policy

Prudent fiscal policy is one in which the government is solvent based on long-run or 'permanent' values of the relevant variables. • Rule implies that whilst the government's expenditure share can be expected to rise above its long-run level in cyclical downturns, this must be reversed in upswings. There is noeconomic reason for a rule to state that the deficit must be limited to a fixed number.

New Fiscal Institutions - why we need them and examples

Rules aren't enough! Need institutions to back them up - the economics world is realising this. All existing independent fiscal institutions are of the watchdog type. They are often labeled fiscal councils UK's example - Office for Budget Responsibility (OBR). Does gov forecasting. Taken over from Treasury preparation of pre and post budget forecasts. OBR is an example of global trend to 'fiscal councils': advisory bodies financed by the state. In most cases they work alongside fiscal rules, either monitoring them (discouraging over-optimism or game playing) or suggesting deviations be permitted (e.g. Sweden during 2008 recession).

Fiscal Policy in the Euro Area: background to 2010.

Since Euro area was established, all the focus has been on debt control implemented at the Euro area level, with little discussion of countercyclical policy. Worried that some countries might go for excessive fiscal stimulus without suffering the consequences! Because mon pol determined in Frankfurt - excess spending would not have negative consequence for individual nation. Key concern is that a union may encourage national fiscal expansion, with harmful 'spillovers'. Pre-2007 interest rates on Euro countries government debt very similar, so no apparent market discipline on governments - Initial concerns were correct!? Problem! With no countercyclical policy, no defence against asymmetric shock.

Economic goals?

Stable prices, full employment and economic growth.

Fiscal policy transition mechanism in ISLM

Standard is a shift in IS curve where the multiplier comes into play to magnify the impact of the fiscal impulse. As level of income rises, demand for money rises, interest rate crowds out interest sensitive spending by private sector. No change in inflation in short run so rise in interest rate means the full multiplier effect of rise in G does not occur. This crowding out will obviously not occur if interest rate held constant.

When will a government default on its debts?

Strategic reasons: 1) Political cost of high taxes/low spending exceed political costs from debt holders plus costs of not being able to borrow again for some time. 2) Political cost from debt holders smaller if a large proportion of debt is owned overseas *** Forced: 1) Even if debt sustainable, if government cannot roll over debt then default is forced if borrowing is in foreign currency, or monetisation occurs if debt is in own currency. Even small probability of default requires a risk premium on debt, which by raising cost of debt, makes default more likely. Vicious circle. How to eliminate risk of default. Borrowing in your own currency! If the market stopped lending the UK government money, the government could just ask the BoE to print some money. Government debt in an economy with its own central bank is a lot more secure.

Balanced budget multiplier

Suppose the government increases taxation enough to finance the increased government spending so that there is no deficit at the new short-run equilibrium. Assume interest rate is fixed and gov increase G and T by the exact same amount. Net effect is the balanced budget multiplier where ∆y / ∆g = 1. What does this conclusion hinge on?: 1) It does NOT depend on assumption that taxes are exogenous 2) government spending generates extra output and income whereas the increase in taxation redistributes spending power form taxpayers to those who provide goods and services 3) groups have same marginal propensity to consumer (as assumed) then balanced budget multiplier is equal to one.

Using fiscal rules (that don't ban deficits)

The argument for fiscal rules might run as follows. The rule embodies something close to best practice (it comes close to an optimal policy that would maximise social welfare). But governments will not always follow best practice, so a rule has to be imposed. If they fail to stick to the rule, they will be punished in some way - perhaps by the electorate, or in a monetary union by the union as a whole. History of fiscal rules is poor, partly because of bad design. Trade off between complexity and simplicity. Governments impose bad simple rules. A good fiscal rule is likely to be complex because debt paths will be contingent on shocks. Examples 1) SGP Pact: 3% deficit limit which was initially broken by large economies because failed to allow for cyclical deficits. (shit rules) 2) GB Rules (good attempts at rules) operated over course of cycle. Blown apart by 2008 recession - not designed for that kind of shock. 3) Osborne - coalition. Rolling 5 year target for cyclically adjust current balance. (clever rule) However others argued complicated and you'd never hit target cause always incentive to cheat. 4) Osborne now. Surplus unless GDP growth < 1%. Less flexible than above rule. Problems with Brown's Golden Rule. Not well designed to keep debt ratio low. Investment projects may not bring in cash returns in long run. A project that will not bring cash returns is, form the perspective of prudent fiscal policy, equivalent to consumption spending by the government and should be financed by a rise in taxation

Formation of Euro Zone as a shock itself and the foundations and solutions to Eurozone debt crisis

The biggest asymmetric shock any of the Euro countries would ever suffer, was joining the Eurozone itself! In ireland and Greece, before Eurozone, interest rates were high because there was a lot of exchange rate and default risk. Moment Eurozone was formed, rates in Ireland and Greece (both short term and long term) came right down! Thus huge monetary stimulus in periphery of Eurozone. Thus they grew a lot - uncontrolled booms. Banks lent money to people they shouldn't! Private financial sector overreached itself and went bust. Thus bailouts for FS needed. This pushed budget deficits up. Exception to this problem - Greece. They just spent too much..! The reason why debt crisis in Greece spread to other countries was because ECB did not (initially) act as lender of last resort. (ECB right to not do this for Greece because they had just overspent but should have backed up Ireland, Spain and Portugal etc). In mid-2012, ECB started lending as lender of last resort - OMT programme. The moment this happened, interest rates on periphery government debt came down, solving the debt crisis at a stroke. German's thought everyone had done what the Greek's had done! So need to implement austerity (across Eurozone) to prevent it happening again. This had hideous effect on GDP. AUSERITY WAS A HUGE MISTAKE!

Wren Lewis 2010 - Macroeconomic policy in light of the credit cruch: the retun of counter-cyclical fiscal policy

The current recession does require a re-evaluation of the role fiscal policy can play when interest rates hit a zero bound. An expansionary fiscal policy is required because monetary policy-makers are reluctant to promise higher future inflation, and the impact of quantitative easing is likely to be small. One theory suggests that if US monetary policy had raised US interest rates more quickly after 2001, the credit crunch could have been avoided. Conclusions rely on a crucial argument, which is that low nominal interest rates lead to a 'search for yield' that encourages excessive risk-taking. This idea is certainly not part of standard economic theory, where preferences for risk are not normally endogenous to the level of interest rates. The credit crunch does not represent a failed macroeconomic policy, but a large negative macroeconomic shock generated by a failure of financial regulation. The key limit is not when a government will probably default, but when the possibility that it will default becomes significant enough for lenders to require a risk premium to offset this chance. To sum up, the consensus assignment needs qualifying in two important ways. First, it is prudent to use fiscal policy in a counter-cyclical manner when there is a significant possibility that interest rates might hit the zero bound. (It should certainly be used once the lower bound has been hit.) Second, there may be many cases in which it is useful to use changes in specific taxes when they operate on the same margin as distortionary shocks, or when they can change relative prices that are away from efficient levels because of nominal inertia.

Automatic Stabilisers

The idea that governments fix tax rates rather than tax levels, they tend to have unemployment regimes such that when unemployment goes up, unemployment benefits go up. Budget deficits rise in downturn because taxes related to income (although this has no impact if Ricardian Equivalence holds) and spending is counter-cyclical. This is a good thing! it cushions the impact of shocks on output. You can't at the same time argue that automatic stabilisers are a good thing but fiscal policy won't influence demand. Obviously contradictory! Fiscal policy is good BECAUSE automatic stabilisers influence demand. NB. Actual deficit = Cyclically adjusted deficit + impact of automatic stabilisers. Thus we should look at cyclically adjusted budget deficit to determine whether fiscal policy is expansionary or contractionary. Cyclically adjusted budget deficit is that which would prevail given existing taxes and spending commitments if the economy was operating at equilibrium output. Hence it measures the discretionary fiscal impulse. NB: Primary budget deficit = discretionary fiscal impulse + impact of automatic stabilisers. Automatic stabilisers may avoid some of the political economy problems noted earlier. How much stabilisation's done by the automatic stabilisers? 1) For tax schedule to act as an automatic stabiliser, necessary that change in agg output leads to change in disposable incoming this in turn leads to change in consumption. In pure PIH, temporary changes in income have no effect on consumption thus automatic stabilisers irrelevant. 2) In the USA, Auerbach and Feenberg find that the tax system offsets about 8% and unemployment benefits about 2% of any initial shock to GDP. 3) Such effects will surely be greater in many European countries with higher tax and more generous unemployment benefits

What should Fiscal Institutions do?

The proposals are of two types: some envisage delegation of actual fiscal policy decisions to an independent fiscal institution, others propose delegation of only forecasting, analysis, evaluation and advising. Options: 1) Monitor whether government follows fiscal rule 2) Adjudicate as to when departures from fiscal rule are allowed 3) Assess whether policy has been appropriate given the shocks to economy 4) Provide objective information on state of economy and outcomes of fiscal policy

Can fiscal consolidation be expansionary?

Theory: 1) Lower the risk premium and thus the interst rate 2) Expectations of future crisis may mean households have reduced their views on expected wealth 3) A fiscal consolidation that was viewed by the public as credible may boost both investment and consumption by reducing the risk premium and restoring optimism about expected wealth. Thus consumers will realise taxes in future have fallen and thus raise consumption now (through borrowing) to smooth. 4) Cutting gov expenditure also puts downward pressure on interest rate (over and above any fall in risk premium) and expected future interest rates may lower as well → investment will rise. Empirics: Empirics suggest that features of policy in countries observed to have expansionary fiscal consolidatiosn were the following; • Expenditure based consolidations • Implementation of a devaluation of the exchange rate IMF - Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand—consumption and investment—falls by about 1 percent. The idea that fiscal austerity triggers faster growth in the short term finds little support in the data. Fiscal retrenchment typically has contractionary short-term effects on economic activity, with lower output and higher unemployment.

Wren-Lewis on Ricardian Equivalence

There is a popular misconception (that may even be shared by the occasional economics professor) that Ricardian Equivalence implies that fiscal policy will not be effective at changing demand. Even if Ricardian Equivalence held exactly, it only implies that the intertemporal income-transfer effect of a tax change has no impact on consumption. Temporary changes in government spending will still have a direct effect on demand. The impact of the change in consumers current or future disposable income will be smoothed, leading to only a small decrease in current consumption. So the net effect on short-run demand is positive, with little crowding-out through lower consumption. Ricardian Equivalence will imply that there is virtually no additional multiplier from temporary government spending increases, but it does not imply that this type of fiscal policy is ineffective.

IMF WEO 2010 - 'Will it hurt? Macroeconomic effects of fiscal consolidation.

These findings suggest that budget deficit cuts are likely to be more painful if they occur simultaneously across many countries, and if monetary policy is not in a position to offset them. • Fiscal consolidation typically has a contractionary effect on output. A fiscal consolidation equal to 1 percent of GDP typically reduces GDP by about 0.5 percent within two years and raises the unemployment rate by about 0.3 percentage point. Domestic demand—consumption and investment—falls by about 1 percent. • Because not all countries can increase net exports at the same time, this find- ing implies that fiscal contraction is likely to be more painful when many countries adjust at the same time. In response to a fiscal consolidation of 1 percent of GDP, the exchange rate depreciates by about 1.1 percent in real terms (see Figure 3.3). Interest- ingly, this real depreciation is almost fully explained by nominal exchange rate depreciation or currency devaluation. When interest rates are stuck at zero, the output cost of fiscal consolidation doubles to about 1 percent after two years. Long-Term Effectsof Reducing Government Debt: 1) Lower real interest rates. 2) ) Lower income taxes The lower interest rates and lower stock of government debt generate savings in terms of lower interest payments that can be used to finance tax cuts.

The Government's Budget Constraint***

This is written in SHARES OF GDP. Most countries have positive government debt, so as long as r > g, they need to turn primary surpluses (d<0) to keep the debt to GDP constant. Four key determinants to understanding the debt GDP ratio: 1) The primary deficit ratio, d 2) the real interest rate, r 3) The growth of real GDP, g 4) the existing ratio government debt to GDP. Key point, is r > g or other way round? 1) if r > g then debt rising unless d is negative. 2) if r < g then primary deficit consistent with constant ratio of debt to GDP.

Minsky Neutrality

When households are highly indebted, face an uncertain employment and labour-income future, and are afflicted by particularly strong risk-aversion, caution, and prudence (that is, when they are suffering from a complete collapse of consumer animal spirits), increases in current disposable income, including those associated with tax cuts or higher transfer payments, may be saved virtually in their entirety. Higher disposable income is devoted to reducing household financial vulnerability by paying down debt.

Bond financing of government spending.

When private sector take bonds to be wealth then change in stock of wealth will influence both consumption and demand for money. Are bonds net wealth? 1) If not considered net wealth, expansionary impact of spending programme shrinks back to that of balance budget. 2) Ricardian equivalence?

When rates hit ZLB in global recession, must fiscal expansions be globally coordinated?

Yes. Prisoners dilemma problem. Positive externality. Doesn't make sense for any one nation to expand as benefit reduced through import leakages. Free rider problem so under provision of fiscal expansion. Yes. Mundell Flemming Model! Any fiscal expansion in small open economy will put upward pressure on domestic exchange rates and thus inflow of foreign capital to hold domestic interest rate at world. Thus appreciation of currency and fall in net exports. Global coordination clearly required. No. Mundell Flemming is incorrect; the inflow of capital from abroad is not sufficient to offset the fiscal stimulus. This is because Forex markets acknowledge temporary nature of expansion and forecast exchange rate will depreciate in the future

crowding out

a drop in consumption or investment spending caused by discretionary changes in fiscal policy, changes in government spending and taxation that are aimed at meeting specific policy goals.

value added tax

a general sales tax collected at each staged of production usa does not have this kind of tax

when the government changes taxes it also effects aggregate supply.... if government increases taxes what would happen?

aggregate supply-output at each price range when businesses are taxed more, they make less money=less motivation to work=less output=shift left on the aggregate supply curve

automatic stabilizers

an element of fiscal policy that changes automatically as national income changes

automatic stabilizers

are elements of fiscal policy that chance automatically as income changes. are government programs that are already in place and that respond automatically to fluctuation in the business cycle., moderating the effects of those fluctuations