a2 economics fiscal policy and demand management

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Fiscal policy and demand management Learning Outcome: To understand the issues of using fiscal policy to manipulate AD :

Fiscal policy and demand management Learning Outcome : To understand the issues of using fiscal policy to manipulate AD

Slide 2:

The objectives of fiscal policy Fiscal policy is decisions about government spending, taxation and borrowing It is an instrument of policy used to achieve 3 main policy goals or objectives To improve macro performance – used to achieve the four main macro objectives by influencing the demand side of the economy (covered in this section) and the supply side (next section) To achieve a more desirable distribution of income and wealth To correct market failure at the micro level Low & Stable Pricing Growth Low unemployment improved BOP

Slide 3:

Demand Management Using fiscal policy to manipulate AD is called Demand Management By reducing tax or spending more withdrawals will decrease and injections will increase thereby increasing the circular flow of money This will be further increased by the multiplier effect (according to Keynesians) This is expansionary fiscal policy – used when there is a negative output gap The opposite is deflationary fiscal policy reducing AD – used when there is a positive output gap

Slide 4:

Automatic stabilisers These automatically increase when the economy is going into a recession They automatically fall when national income begins to rise Government spending and taxation are both automatic stabilisers When the economy goes into recession and unemployment rises government increases spending on benefits The fall in AD is therefore less than it would otherwise have been Tax revenues fall too at a higher rate than the fall in income This is due to the fact that tax rates tend to be higher on marginal income than on average income Automatic or built-in stabilisers – mechanisms which reduce the impact of changes in the economy on national income spending Taxation

Slide 5:

Automatic stabilisers An example to show you how the tax falls at a faster rate than the fall in income A worker paid on commission sells less in a recession Her tax rate might fall from 40% to 20% If household spending has to be cut then it is more likely to be on consumer durables taxed at 20% VAT than zero rated goods such as food With the government collecting les tax disposable incomes are higher and consumption is at a higher level that it would be without the stabiliser Automatic or built-in stabilisers – mechanisms which reduce the impact of changes in the economy on national income

Slide 6:

Automatic stabilisers When the economy goes into a boom Unemployment decreases Government spending falls as the benefits fall automatically Tax revenue increases at a faster rate than income An unemployed person will pay very little tax Once they get jobs they start to pay substantial amounts of direct and indirect tax AD is lower than it would otherwise be with these automatic stabilisers Automatic or built-in stabilisers – mechanisms which reduce the impact of changes in the economy on national income Boom Benefits Fall Tax Revenue Increases

Slide 8:

Active or discretionary fiscal policy to manipulate AD This does not rely on the economy automatically changing the amount of government spending or collecting tax This is deliberate manipulation of government expenditure and spending to influence the economy In the 1920s and 1930s the orthodox classical thinking of the day was that governments should maintain balanced budgets whatever the state of the economy The argument was that for every £1 of government spending would crowd out private sector spending This would cancel out the affect of the government spending on AD Active or discretionary fiscal policy – the deliberate manipulation of government expenditure and taxes to influence the economy

Slide 9:

Active or discretionary fiscal policy to manipulate AD Keynes argued that crowding out did not take place in an economy that was in a depression Post war (50s and 60s) governments used fiscal policy to manage demand At this time unemployment was low and demand management was just a matter of fine tuning In the 1970s and 80s they were suffering from high unemployment and high inflation and returned to the crowding out argument Today the mainstream view is that AD should be manipulated through the use of monetary policy Fiscal policy is best left to deal with correcting market failure or changing inequality because…… Fine tuning – the attempt by government to move the economy to a very precise level of unemployment, inflation etc Use Monetary policy to change AD

Slide 11:

The limitations of using fiscal policy to manipulate AD Conflicting policy objectives Governments in the past believed that they could achieve a variety of objectives using fiscal policy This led to stop-go cycles When the economy was in recession the government would use expansionary fiscal policy to reduce unemployment and stimulate growth The economy would overshoot In the subsequent boom inflation would rise and the BoP would deteriorate Government would put on the brakes and use deflationary fiscal policy sending the economy back into recession This was made worse by creating booms around election times In contrast monetary policy targets only one variable – the rate of inflation Giving monetary policy to the MPC removes election time manipulation Stop/go cycle – the movement from boom to recession in the trade cycle

Slide 12:

The limitations of using fiscal policy to manipulate AD Time lags Assume government announces £500m increase in civil servant salaries and £500m increase in road building If the multiplier were 2 this would lead to a £2000m increase in circular flow income (in the Keynesian model) However this could take years to work through the economy Salaries might work quickly Road building make take years to even start Government has to take these time lags into consideration when using fiscal policy to manipulate AD If it wants to make quick changes it has to change taxes and items of expenditure that have an immediate impact on AD E.g. income tax rates, social security payments and public sector wages Not road building or hospital building Time Lag Multiplier

Slide 13:

The limitations of using fiscal policy to manipulate AD Time lags Governments have been accused of destabilising the economy using fiscal policy If the economy was starting to move into a boom on its own accord and the government at the same time used expansionary policy there would be a positive output gap and inflation Some economists argue that the inability to predict time lags accurately makes it impossible to use fiscal policy to fine tune the economy Fine tuning is impossible with time lags

Slide 14:

The limitations of using fiscal policy to manipulate AD Inadequacy of economic data Active fiscal policy assumes that the Chancellor knows the current state of the economy But…statistics are notoriously unreliable Unemployment and inflation stats are not revised after publication National income and BoP stats are frequently revised Often two or more sets of figures which should match fail to do so If there is a deficit on the BoP the chancellor will not know how much of this is genuine deficit and how much is inaccurate recording of stats Fine tuning can then be very difficult

Slide 15:

Insert Q3

Slide 16:

The limitations of using fiscal policy to manipulate AD Inadequate economic knowledge Active fiscal policy assumes that we know how the economy behaves There is scepticism that economics will ever be able to predict changes in variables to the last few % Many of the variables that governments wish to control have very small values A government may wish to reduce growth from 3% to 1.5% Fiscal policy is unlikely ever to be sufficiently sensitive to achieve exactly that 1.5% fall

Slide 17:

The limitations of using fiscal policy to manipulate AD The inadequacy of the model Computer based macro forecasting models used today are highly complex At best they provide an approximation of possible outcomes The data (particularly the most recent data) fed into the models may not be accurate They cannot forecast economic shocks Until the 1980s UK forecasting models failed to take into account the importance of large changes in house prices for AD Today there is controversy about the significance of the IT revolution Some economists say it has improved productivity that is not showing in traditional models The models are not showing the potential growth without inflation Others are sceptical and remember the miracle economy of the 1980s created through supply side reforms that led to an overheated economy economic models not good enough

Slide 18:

The limitations of using fiscal policy to manipulate AD Fiscal policy and monetary policy Fiscal policy cannot be independent of monetary policy If government increases borrowing it has to be financed Governments can print money to do this Printing money increases the money supply and is potentially inflationary Printing money and increasing the money supply is a monetary policy decision Hence fiscal policy and monetary policy are interlinked

Slide 19:

The limitations of using fiscal policy to manipulate AD Fiscal policy and monetary policy Governments can avoid printing money by borrowing from the private sector This increases the demand for borrowed funds and interest rates are likely to rise Higher interest rates will reduce the willingness of the private sector to borrow and spend The increase in AD from a higher G will to some extent by offset by reduced AD from decrease in I Allowing interest rates to rise is part of monetary policy and again this shows how monetary and fiscal policy are linked

Slide 20:

The limitations of using fiscal policy to manipulate AD Fiscal policy and monetary policy Higher government borrowing may not lead to higher interest rates if the economy is in a deep depression This is called a Liquidity Trap situation Liquidity trap – where the economy is in such a deep depression that interest rates have fallen as far as they will ever go. This means that governments cannot use monetary policy through reducing interest rates to stimulate AD. Only fiscal policy can help revive demand

Slide 22:

The limitations of using fiscal policy to manipulate AD The national debt Since the 2 nd WW many governments have abandoned attempts to balance their budgets They find it politically easier to spend more than they tax and borrow the difference The problem is that the borrowing may become very difficult to service (pay the interest) They may get to the point where the majority of revenue taken in tax is used to pay the interest – they still have to pay the capital Eventually lenders will be scared that the government will default on its debt The country may have its credit rating reduced This will increase the amount of interest the country has to pay on its debt AAA

Slide 23:

The limitations of using fiscal policy to manipulate AD The national debt In the short term the government could print money More supply may lead to inflation Inflation reduces the value of the debt This is not a long term solution Lenders will demand much higher interest rates if there is high inflation Budget deficits will continue to increase the size of the national debt

Slide 24:

The limitations of using fiscal policy to manipulate AD Stability and growth pact When plans were made to create the European Monetary Union it was recognised that large budget deficits and a sizable national debt could destabilise the economies of individual member countries and therefore the whole union As a condition of membership the fiscal deficits could not be more than 3% of GDP The national debt of a country could not be more than 60% of GDP This stability and growth pact further limits the ability of governments of member countries to use fiscal policy to steer economies Fiscal Debt No More than 3% of GDP

Slide 25:

The limitations of using fiscal policy to manipulate AD Code for Fiscal Stability In the UK the government has had its own set of fiscal rules since 1998 The golden rule states that the government will only borrow to invest (to build hospitals etc) and not to fund current spending (e.g. wages, salaries, rent, heating etc) The sustainable investment rule states that the national debt will be kept at 40% of GDP These rules would limit the use of fiscal policy to manipulate AD Have they kept to these rules recently? Only Borrow to Invest

Homework:

Homework Question 5 June 2010 The Budget Report of April 2009 estimated that UK government borrowing for 2009-10 would be £175 billion, or about 12% of GDP. Explain possible economic reasons for changes in the level and distribution of government expenditure. (15 marks) To what extent should government borrowing be a cause for concern? (25 marks)

Slide 27:

First part of the first question - explain reasons for changes in the level of expenditure , e.g. cyclical: in a recession, for example, welfare spending will automatically increase as more of the population become eligible, but government may also decide to spend more over and above this in order to minimise the recession and initiate a multiplier effect through capital project schemes new decisions made over the provision of merit goods new decisions made over the provision of public goods to influence the distribution of income changed priorities regarding the drive to reduce poverty and the general standard of living of the population to underpin key sectors of the economy, e.g. financial services, the car industry changing taxation revenue allows an increase in, or makes it necessary to reduce, government spending changing views on government borrowing to finance spending plans You would probably only want to explain a couple of these and then the same for the distribution

Slide 28:

Second part of first question: explain reasons for changes in the distribution of government expenditure, e.g. changing economic circumstances, brought about by changing domestic or international conditions, which in addition to changing the level of spending, may cause governments to have to re-distribute spending, e.g. reducing defence spending in order to give more support to domestic sectors of the economy, e.g. banks or postponing capital projects in order to increase welfare payments the changed priorities of a new government compared to the previous government or a long-standing existing government trying to breathe new life into itself, e.g. action on poverty might cause less spending on transport demand-determined items of expenditure (perhaps reference to a cyclical/structural distinction) the impact of an ageing population changing levels of concern internationally over environmental issues forces the UK government to commit more spending to the problem which could reduce, for example, the government financial support for the arts/culture etc public or private sector investigations and reports highlight failings in key parts of the public sector, notably education and the NHS, and these are therefore given priority in spending over defence, for example the topical issue of interest payments on the National Debt

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