FISCAL POLICY · Fighting Inflationary Gap Whenever there is an inflationary gap in the economy, the government adopts deflationary fiscal policies of lowering government expenditure

College of Education

School of Continuing and Distance Education2014/2015 – 2016/2017

FISCAL POLICY

Lecturer: Dr. Priscilla Twumasi Baffour, Department of Economics Contact Information: [email protected]

Session Overview

• This session discusses fiscal policy which is the managementof taxes and/or government spending by the government forthe purpose of altering real national output and employment,combating inflation and stimulating growth. Bothexpansionary and contractionary fiscal policies are discussedin addition to an explanation of discretionary fiscal policy andautomatic stabilizers.

• The session further a discusses howrecessionary/deflationary and inflation gaps can be closedwhen they occur and concludes with definition andderivation of the balance budget multiplier.

Priscilla T. Baffour

Session Outline

The key topics to be covered in the session are as follows:

• The key topics to be covered in the session are as follows:– Fiscal policy definition and objectives

– Tools of fiscal policy

– Types of fiscal policy

– Discretionary fiscal policy

– Automatic stabilizers

– Deflationary gap

– Inflationary gap

– The Balanced budget multiplier


Learning Outcome

• After completing this session, you should be able to;– Define fiscal policy and identify the two main types of fiscal

policy– Explain the effects of fiscal policy on aggregate output– Discuss discretionary fiscal policy– Identify automatic stabilizers and describe how they work in the

economy– Describe both deflationary and inflationary gaps and illustrate

them using diagrams– Appreciate policies that can be used to close both deflation and

inflationary gaps when they occur in the economy– Derive the balanced budget multiplier and show the different

impact it has on output when there is only indirect tax andwhen there are both direct and indirect taxes.


Reading List

• Read Chapter 19 of John Sloman; Economics, 8th Edition(2011), Pearson

• Session Slides

• Watch video on session 6 ……………………..

• Any Other Economics text books available to students


Fiscal Policy

• Fiscal policy is the use of government budget toencourage(boost) sustained economic growth and reduce thelevel of fluctuations in the business cycle. Or

• Fiscal policy is the management of taxes and/or governmentspending by the government for the purpose of altering realnational output and employment, combating inflation andstimulating growth.

• Simply, fiscal policy is the means by which a governmentadjusts its spending levels and tax rates to monitor andinfluence a nations economy.


Objectives of Fiscal Policy

Fiscal policy has some objectives it seeks to achieve. This includes:

– Full employment

– Price stability

– Economic growth

– Optimum allocation of resources

– Equitable distribution of income and wealth


Tools of Fiscal Policy

• In the pursuit of fiscal policy, the government usestwo main instruments.

– Taxation

• Taxes provide a major revenue that funds governmentspending.

– Government Spending

• This includes subsidies, transfer payments, public workprojects, government salaries etc.


Types of Fiscal policy

• There are two main types of fiscal policy. These are

– Expansionary Fiscal Policy

– Contractionary Fiscal policy.

• Other types of fiscal policy includes

– Discretionary Fiscal Policy

– Automatic Fiscal policy.


Expansionary Fiscal Policy• Expansionary fiscal policy is a policy whereby government budget is used

to boost or increase aggregate demand in the economy if real GDP isfound to be below potential level.

• Simply, expansionary fiscal policy is designed to stimulate the economyduring or in anticipation of a business cycle contraction(A recession).

• It is also known as fiscal expansion.

• Expansionary fiscal policy brings about a reduction in unemployment.

• Expansionary Fiscal policy involves:

– Increase in government purchases

– Increase in transfer payments

– A decrease in taxes

• Households have more disposable income to spend with areduction in taxes and this increases consumption.


Expansionary Fiscal Policy

• Expansionary fiscal policy will lead to an increase in the size ofgovernment budget deficit and also lead an increase in thegeneral price level.

• A decrease in taxes leads to a higher disposal income forhouseholds which in turn increases consumption and thenincreases GDP. Also since government expenditure is acomponent of GDP, an increase in government expenditureincreases GDP as well.

• From the diagram in slide 13 below, an increase in governmentspending and a decrease in taxes increases GDP thereby shiftingthe aggregate demand curve from 𝐴𝐷0to 𝐴𝐷1. This increases realGDP from 𝑌0 to 𝑌1.


SARS

AD0

Real GDP

[i]. Aggregate demand

P1

P0

Y0

Graphical Illustration of Expansionary Fiscal Policy

E0

Y’1

E1

AD1


Contractionary(Restrictive) Fiscal Policy

• This is a form of fiscal policy where government budget is used to correctthe inflationary pressures of business-cycle expansion.

• Simply, it involves the use of government budget to cut down or restrictaggregate demand if it is observed that real GDP is above the potentiallevel.

• It is also know as Fiscal contraction.

• The goal of a contractionary fiscal policy is to close an inflationary gap,restrain the economy and decrease the rate of inflation.

• Contractionary fiscal policy involve:

– Decrease in government purchases

– Increase in taxes

– Decrease in transfer payments


Contractionary Fiscal Policy

• An increase in taxes leads to a lower disposal income forhouseholds which in turn decreases consumption and thendecreases GDP.

• Also given government expenditure is a component of GDP, adecrease in government expenditure decreases GDP.

• From the diagram in slide 15 below, a decrease in governmentspending and/or an increase in taxes decreases GDP therebyshifting the aggregate demand curve from 𝐴𝐷0to 𝐴𝐷1. Thisdecreases real GDP from 𝑌0 to 𝑌1.


SARS

AD1

Real GDP

[i]. Aggregate demand

P0

P1

Y1

Graphical Illustration of a Contractionary Fiscal Policy

E0

Y’0

E1

AD0


Discretionary Fiscal Policy

• Discretionary fiscal policy is a government action beyondexisting fiscal policies which often occurs in period ofrecession and economic turbulence.

• That is, it is a fiscal policy action that is initiated bygovernment legislation, an act of parliament which may benecessitated by the need for a change in spending program orin tax law.

• Example of discretionary fiscal policy include an increase intax rate or an increase in educational spending.


Automatic Fiscal Policy

• Automatic fiscal policy is a fiscal policy that istriggered by the state of the economy and involvesno direct action from the government.

• Automatic stabilizers are usually defined as thoseelements of fiscal policy which reduce tax burdensand increase public spending without anydiscretionary government action.

– Example of an automatic stabilizer is the marginal orproportional tax rate such as the income tax rate. Theamount of revenue collected in income tax increases withincrease in income without a change in the tax rate and assuch acts as a stabilizer in the economy.


Deflationary /Recessionary Gap

If the equilibrium level of output as determined bythe AD (aggregate demand) and AS (aggregatesupply) is not equal to the level of full employment,then two situations can arise.

– Either this equilibrium level will be below or above the fullemployment level.

– In case, the equilibrium income is below the potentialincome, it indicates the presence of recessionary gap.

– On the other hand, if it is above the full employmentincome, then there is the presence of inflationary gap.


Deflationary /Recessionary Gap

Deflationary gap also known as a re-cessionary gap.

When there is an insufficient demand for goods and services inthe economy, the equilibrium will occur at a lower level ofoutput below (left of full employment) output line.

In other words, re-cessionary gap occurs when the aggregatedemand is not sufficient to create conditions of fullemployment.

The deflationary gap thus is the amount by which aggregateexpenditure falls short of the level needed to generateequilibrium national income at full employment.


Fighting Recession

• When the economy is operating below its potentialoutput (income) level, the government recognizesthe re-cessionary gap in aggregate income andincreases its expenditures to stimulate the economy.

– The multiplier process takes over.

• Thus, expansionary fiscal policy can be used to closethe gap:

– Increase in Government expenditure

– Reduction in Taxes


Inflationary Gap• An inflationary gap is just the opposite of a deflationary

gap.– It exist when equilibrium income exceeds full employment

income. It is created aggregate demand is in excess of thefull employment level.

• Inflationary gap is the difference between equilibriumincome and full employment income (potential income).When equilibrium income exceeds full employmentincome.– This simply means people are trying to buy more goods and

services than can be produced when all resources are fullyemployed.

– The result is that the excess demand pulls up prices whichcauses inflation. Thus the excess demand for goods andservices is being met in money terms but not real, terms.


Fighting Inflationary Gap

Whenever there is an inflationary gap in the economy, thegovernment adopts deflationary fiscal policies of loweringgovernment expenditure and/or raising taxes.

It also adopts deflationary monetary policy to reduce theamount of money in the economy (we will discuss this furtherunder monetary policy).


Balanced Budget Multiplier

• The balanced budget multiplier states that an increase ingovernment spending accompanied or financed by an equalincrease in taxes results in an equal increase in equilibrium incomeor output.

• If government spends by raising the same amount in tax revenue,ideally one would think that it will cancel out and have no effect onoutput.

• However, because government spending has a greater impact onoutput than taxes, the balance budget scenario will always lead toan increase in output.

• Note; Given, government is increasing spending by raising the sameamount in taxes from the citizens, the extent of the impact of thisaction on the level of equilibrium income will be the governmentspending multiplier plus the tax multiplier.


Derivation of the Balanced Budget Multiplier

• In the case of Government Spending and indirect taxes, the

sum of the two multipliers is given as;

• Balanced Budget multiplier=𝑑𝑌

𝑑𝐺0+

𝑑𝑌

𝑑𝑇0=

𝟏

𝟏−𝐛+

−𝐛

𝟏−𝐛=

𝟏−𝐛

𝟏−𝐛= 𝟏

• This implies that if government increases government

spending by 500 and finances it by raising taxes of 500,

equilibrium output will increase by 500.


Derivation of the Balanced Budget Multiplier

• In the case of Government Spending and net taxes (i.e. both

direct and indirect taxes), the sum of the two multipliers is

given as;

• Balanced Budget multiplier=𝑑𝑌

𝑑𝐺0+

𝑑𝑌

𝑑𝑇0=

𝟏

𝟏−𝐛(𝟏−𝐭)+

−𝐛

𝟏−𝐛(𝟏−𝐭)=

𝟏−𝐛

𝟏−𝐛(𝟏−𝐭)< 1

• This implies that if government increases spending by 500 and

finances it by raising taxes of 500, equilibrium output will increase

by less than 500.


Sample Questions

• Classify each of the following discretionary fiscalpolicies as either restrictive or expansionary

– Additional expenditure to upgrade roads

– A purchase of ghc500,000 additional anti-malaria drugs

– A cut in funding for the military

– An increase in public educational budget


Documents

FISCAL POLICY · Fighting Inflationary Gap Whenever there is an inflationary gap in the economy, the government adopts deflationary fiscal policies of lowering government expenditure