Fiscal policyFiscal policy1. State Budget2. Supply Side Economy3. Government Expenditure Multiplier4. Tax Multiplier5. Expansionary Fiscal Policy6. Crowding Out Effect

Fiscal policyFiscal policy

Fiscal Policy is the process of shaping taxation and public expenditures in order to help to reduce business cycle fluctuations and to maintain high economic growth.

State BudgetState Budget

Governments use budget to control and record their fiscal affairs.

A budget shows, for a given year, the planned expenditures of government programs and the expected revenues from tax systems.

State BudgetState Budget

State budget revenues:◦ Tax Revenues:

Tax on income, profit and capital gain

Property tax Domestic taxes on goods and

services (value added tax, excise taxes, road tax)

◦Non-tax revenues Administrative and other charges and

payments Capital income Interest on domestic and foreign

credits, loans and deposits

◦Grants and transfers◦Revenues from financial

transactions (repayments of credits and loans)

State budget State budget expenditureexpenditure

◦ Current expenditures Wages, salaries, Insurance premiums and contributions to

insurance companies and to the National Labour Office,

Current transfers (state social benefits) Payments of interest and other payments

in link with loans received Purchases of goods and services

◦ Capital expenses◦ Expenses in link with financial

transactions (credits and loans extended)

Budget Surplus and Budget Surplus and DeficitDeficit

A budget surplus occurs when all taxes and other revenues exceed government expenditures.

A budget deficit occurs when expenditures exceed revenues.

When expenditures and revenues are equal during a given period, the government has a balanced budget.

Structural and Cyclical Structural and Cyclical Budget Budget

The structural budget calculates what government revenues, expenditures and deficits would be if the economy were operating at potential output.

The cyclical budget calculates the effect of the business cycle on the budget – measuring the changes in revenues, expenditures, and deficits that arise because the economy is not operating at potential output.

Financing DeficitFinancing DeficitGovernment can borrow funds from the other

sectors of the economy. This involves the selling of government securities such as treasury bonds. Government competes with the private sector for domestic savings, creating what is referred to as a “crowding out effect”.

Government supports export.Government sells securities to the central

bank. This form of borrowing from the CB basically means that the government prints money to finance the deficit.

Government borrows funds from international financial markets. If government borrows funds from overseas it can reduce the crowding out effect.

Fiscal Policy Instruments Fiscal Policy Instruments

Automatic stabilizers act to reduce business-cycle fluctuations.

Discretionary fiscal policy is one in which government changes tax rates or spending programs. In contrast to automatic stabilizers, discretionary policies generally involve passing legislation to change the structure of the fiscal system.

Automatic StabilizersAutomatic Stabilizers

Progressive taxes – the average tax rate rises as income rises. In inflationary times, an increase in tax revenues will lover personal income, dampen consumption spending, reduce aggregate demand, and slow the upward spiral of prices and wages.

Automatic StabilizersAutomatic Stabilizers

Unemployment insurance, welfare and other transfers are designed to supplement incomes and relieve economic hardship.

Subsidies on production in the farm sector.

Discretionary Fiscal Discretionary Fiscal PolicyPolicy

Public works include public investment projects designed to create jobs for the unemployed. Those projects are highly capital-intensive and long-duration ones.

Public employment projects are designed to hire unemployed people for periods of a year or so, after which people can move to regular jobs in the private sector.

Discretionary Fiscal Discretionary Fiscal PolicyPolicy

Varying tax rates can be used to either stimulate or restrain an economy. Once taxes have been changed, consumers react quickly; a tax cut is spread widely over the population, stimulating spending on consumption goods.

Supply Side Economy Supply Side Economy

Toward the end of the 1970s, critics of the conventional approach to macroeconomics argued that economic policy had been too oriented toward the management of aggregate demand.

New school of supply side economics proposed large tax cuts to reverse slow economic growth and slumping productivity growth.

Supply Side Economy Supply Side Economy

Three central features of supply side economics:◦ Retreat from Keynesian demand-

management policies;◦ Emphasis on incentives and supply

effects;◦ Advocacy of large tax cuts

Laffer CurveLaffer Curve

Forbidden zone

Tax Rate100%0

Tax Revenues

A

B

C

D

t1 t2 t3

Government Expenditure Government Expenditure MultiplierMultiplier

The government expenditure multiplier (g) is the increase in GDP resulting from an increase in government expenditures on goods and services.

The government expenditure multiplier (g) is the same number as the investment multiplier:

ΔGDP = g . ΔG

MPCg

1

1

Government Expenditure Government Expenditure MultiplierMultiplier

C + I + G + ΔG

C + I + G

Q0 Q1

Q2

C,I,G

QP

E1

E2

Tax MultiplierTax Multiplier

Tax multiplier (t) is smaller than the expenditure multiplier by a factor equal to the MPC: t = g . MPC

ΔGDP = t . ΔT

MPS

MPC

MPC

MPCt

1

Tax MultiplierTax Multiplier

C2 + I + G

C1 + I + G

Q0 Q1

Q2

C,I,G

QP

E1

E2

Expansionary Fiscal Expansionary Fiscal PolicyPolicy

When the economy is operating underthe potential output, inthe short-run, rightward shift of AD curve haseffect on real outputwith only a small effect on prices.

Q

P

AS

ADAD

1

QP

Q Q1

EE1

P

P1

Expansionary Fiscal Expansionary Fiscal PolicyPolicy

Lung-run expansionary fiscal policy , will primarily raiseprices and nominal GNPwith no effect on real GNP.

Q

P

LRAS = QP

ADAD

1

QP

0

E

E1

P

P1

Restrictive Fiscal PolicyRestrictive Fiscal Policy

Restrictive fiscal policy includes:◦Reduction in government spending◦Reduction in trasfer payments◦Higher tax rates

In the long run reduction in government spending can lead to higher business investment, that will replace this reduction.

Crowding Out EffectCrowding Out Effect

The crowding out hypothesis: government spending reduces private investment. When government spends people's money on public works projects these funds simply crowd out private investment.

Complete Crowding Out Complete Crowding Out EffectEffect

C + I + G1

C + I1+ G1

Q0 Q Q1

C,I,G

QP

E

E1

C + I + G

Complete Crowding Out Complete Crowding Out EffectEffect

The government enacts a spending program, increasing government spending on goods and services from G to G1. As a result we have the new C + I + G1 line. If there were no monetary reaction, GNP would rise from Q to Q1. Because of the monetary reaction, interest rates rise and reduce investment to I1. The monetary reaction is so powerful that the new spending line is C + I1 + G1 with a new equilibrium level of output, which is exactly the old equilibrium E.