FISCAL POLICY

Fiscal policy refers to the manipulation of government revenue and expenditure to

achieve policy objectives associated with:

 Moderating resources allocation and adjusting price mechanisms in favour of the

satisfaction of public wants by encouraging socially optimal investments as well
as increasing rate of investments;
 Redistributing wealth income;
 Guiding the national economy in terms of growth and stability;
 Increasing employment opportunities;
 Counteracting inflation; and
 Improving the balance of payments.

Fiscal policy uses government purchases, transfer payments, taxes, and borrowing to
affect macroeconomic variables such as employment, the price level, and the level of
GDP.

Instruments of fiscal policy

The main instruments of the fiscal policy are
 taxes
 expenditure
 public debt

These are the constituent parts of the budget of the country. Therefore budgetary policy
of the government will be the major tool through which the government tries to
implement the objectives.

The usefulness of fiscal policies if often limited by:

 Structural constraints in the economies; and

 Observed conflicts of objectives between long term growth and short term stability;
social welfare and economic growth; income distribution and growth and personal
freedom and social control.

Basically, fiscal policy can be applied in many ways to influence the economy. For
example
 The government can increase its own expenditure which it can influence by raising
taxes, by borrowing from non bank members of the public and/or borrowing from
the Central and Commercial bank.
  Borrowing from non - bank members of the public often raises interest rates and
reduces availability of credit to the private sector forcing a reduction in the sectors
of consumption and investment expenditures.
 Borrowing from the Central Bank increases money supply and may give rise to
inflation and balance of payments problems.

Taxes can be used to change the consumption of demand in the economy and to affect
consumption of certain commodities.

COMPENSATORY FISCAL POLICY

Tools of fiscal policy:

1. Automatic Stabilizers – Structural features of government spending and taxation that

smooth fluctuations in disposable income, and hence consumption, over the business
cycle.

- Federal Income Tax

2. Discretionary Fiscal Policy – The deliberate manipulation of government purchases,

taxation, and transfers in order to promote macroeconomic goals such as full
employment, price stability, and economic growth.

- Changes in Government Purchases

II. Discretionary Fiscal Policy

A. Changes in Government Purchases

Example:

D Real GDP = DG * (1/1-MPC)

B. Changes in Net Taxes

Decrease in net taxes à increases disposable income à consumption increases à increases

real GDP demanded.
Increase in net taxes à decreases disposable income à consumption decreases à decreases
real GDP demanded.

Example:
 Simple tax multiplier- The ratio of a change in equilibrium real GDP demanded to the
initial change in autonomous net taxes that brought it about; the numerical value of the
simple tax multiplier is -MPC/1-MPC.
D Real GDP = DNT * (-MPC/1-MPC)

Notes:
1. Increase in government spending, increases equilibrium real GDP demanded.
(simple government purchase multiplier >0)
2. Increase in net taxes, decreases equilibrium real GDP demanded. (simple tax
multiplier <0)

III. Including Aggregate Supply (Discretionary Policy Continued)

Often natural market forces will take a long time to close a contractionary gap.

A. Discretionary Fiscal Policy in Response to a Contractionary Gap

Suppose that in short-run equilibrium, we have a contractionary gap. Unemployment is

above the natural rate. If the market adjusts naturally, the nominal price of resources will
drop in the long run; short-run aggregate supply would shift out to achieve equilibrium at
potential output.

Often, however, wages and prices are slow to adjust. Government may introduce fiscal
policy to move the economy more quickly back to potential output. They might change
net taxes or government spending or both.

B. Discretionary Fiscal Policy in Response to an Expansionary Gap

If short-run equilibrium price level exceeds the level on which long-term contracts were
based, output exceeds potential GDP. In the long run, we expect the short-run aggregate
supply curve to shift back, returning the economy to potential output and increasing the
price level.

Use of discretionary fiscal policy can avoid inflation.

Example:
Precisely calculated fiscal policies are hard to achieve because the government must
know:
1. The spending multiplier
2. Whether aggregate demand can be shifted the correct amount
3. What the potential output level is
4. How to coordinate fiscal efforts among government agencies
5. The shape of aggregate supply curve in the short run

C. The Multiplier and the Time Horizon

The steeper the short-run aggregate supply curve, the less impact a given shift in the
aggregate demand curve has on output and the more impact it has on the price level, so
the smaller the spending multiplier.

If the economy is already producing its potential output, the spending multiplier is zero in
the long run.

IV. Problems with Discretionary Fiscal Policy

A. Fiscal Policy and the Natural Rate of Unemployment

To use discretionary fiscal policy, public officials must correctly estimate the natural rate.

B. Lags in Fiscal Policy

The time required to approve and implement fiscal policy may make it less effective as a
tool for stabilization. Imposed at the wrong time, measures may cause more harm than
good.

C. Discretionary Policy and Permanent Income

Permanent Income – Income individuals expect to receive on average over the long term.

People base their consumption decisions not just on current income but also on
permanent income.
If people view tax changes as only temporary, they will not have their desired effect.

Example: Temporary tax surcharge increase in 1967

To the extent that consumers base spending decisions on their permanent income,
attempts to fine-tune the economy with tax-rate adjustments thought to be temporary will
be less effective.

D. Feedback Effects of Fiscal Policy on Aggregate Supply

Fiscal policy may affect aggregate supply, often unintentionally.

Changes in transfer payments/taxes not only affect AD, but could cause changes in the
labor supply.

Both automatic stabilizers, unemployment insurance and the progressive income tax, and
discretionary fiscal policy, such as changes in tax rates, may affect individual incentives
to work, spend, save, and invest, although these effects are usually unintended.

VI. Automatic Stabilizers

Automatic stabilizers smooth fluctuations in disposable income over the business cycle,
thereby boosting aggregate demand during periods of recession and dampening aggregate
demand during periods of expansion.

Example
Federal Income Tax system is progressive (fraction of income paid in taxes increases as
income increases).
Expansion à growing fraction of income goes to taxes à slowing the growth in DI and C.
This relieves the inflationary pressure associated with expansions.

Example
Unemployment Insurance
Recession à unemployment increases à payments are made from the insurance fund to
those who are unemployed à This increases their disposable income and decreases the
impact of the recession.

Because of Automatic Stabilizers

1. GDP fluctuates less than it otherwise would
2. Disposable Income varies proportionately less than does real GDP

The stronger automatic stabilizers are, the less the need for discretionary fiscal policy.

Difficulties in using fiscal policy

There are several problems involved in implementing fiscal policy. They include:

Theoretical problems
Monetarists and the Keynesians do not seem to agree on the efficacy of fiscal policy.
Monetarists claim that budget deficits (or surpluses) will have little or no effect upon real
national income while having adverse effect upon real national income while having
adverse effects upon the interest rates and upon prices.

The net effects of the budget

Unlike the simple Keynesian view that various types of budgets have different effects, the
empirical evidence is that the net effects of taxes and government expenditure are
influenced by the marginal propensities to consume of those being taxed and governments
expenditure.

The Inflexibility of government finances

Much of the government’s finances are inflexible. One of the reasons for this is that the
major portion of almost any departments budget is wages and salaries, and it is not possible
to play around with these to suit the short-run needs of the government.

Discretionary and automatic changes

Discretionary changes are those which come about as a result of some conscious decision
taken by the government, e.g. changes in tax rates or a change in the pattern of
expenditure.

Automatic changes come about as a result of some changes in the economy, e.g. an
increase in unemployment automatically increases government expenditure on
unemployment benefits.

In fact it is the case that deficits tend to increase automatically in times of recession and
decrease in times of recovery. (These fiscal weapons which automatically increase in
times of recession and decrease in times of recovery are referred to as brick stabilizers). It
is possible for a government to compound the effects of a recession by raising taxes in
order to recover lost revenues. This, according to Keynesians, would cause a multiplier
effect downwards on the level of economic activity.

Policy conflicts
When devising its fiscal policy, the government must attempt to reconcile conflicting
objectives of policy. For example, there is commonly supposed to be a conflict between
full employment and inflation, i.e. that the attainment of full employment may cause
inflation.

Information
It is very difficult to assemble accurate information about the economy sufficiently quickly
for it to be of use in the short-run management of the economy.

Time lag
It normally takes time for a government to appreciate the economic situation, to formulate
a policy and them implement it. This leads to lagged responses some of which may be
long and difficult to predict.

For instance, there is an inside lag which is the time interval between the recognition of an
economic problem or the shock and the implementation of appropriate policy measures.
This is the time it takes to recognize that the shock has taken place and then to formulate
and implement an appropriate policy. In general, fiscal policy is thought to have a longer
inside lag than monetary policy.

Finally, there is an outside lag when the time interval between the implementation of policy
measures and the resultant effects on the intended targets.

The neo-classical view

The neo-classical view is that market forces are the best directors of the economy. Positive
attempts by the government it is argued inevitably make things worse. The correct posture
for fiscal policy, therefore, is simply to minimize the role of government, thus leaving the
largest proportion of the economy possible to be run by the market forces.