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Fiscal Policy
Sustainability:
The public sector is usually divided into three sub sectors; the central government, local government
and the social security system
...
Public sector expenditure consists of consumption, investment, transfers and interest
payments and public sector income consists of taxes and social contributions
...
e
...
As a
generally rule, government spending/debt is sustainable as long as net debt grows slower, on
average, than GDP
...

A simple equation for the sustainability of government debt is:
∆𝐷
𝐺 − 𝑇 (𝑟 − 𝑔)𝐷
=
+
𝑌
𝑌
𝑌
Where the LHS represents the change in the debt to GDP ratio, G represents government spending,
T represents income from taxation, r represents the real interest rate and g represents the real
growth rate
...
If
the debt ratio is to remain constant the two components on the RHS of the equation must be equal
...
To express the equation above in these
terms we use the fact that the real interest rate is equal to the nominal interest rate and substitute
this into the equation:
∆𝐷
𝐺 − 𝑇 + 𝑖𝐷 (𝜋 + 𝑔)𝐷
≈
−
𝑌
𝑌
𝑌
(𝜋+𝑔)𝐷

Using this equation we can see that we can have a deficit relative to GDP which is equal to
𝑌
and still keep the debt ratio constant
...
Furthermore, expected future changes should be taken into account when evaluating the
sustainability of government finances and to evaluate the long-term sustainability of public finances
projections must be made for what future expenditures will be on things such as health and
pensions
...

To stabilise the debt-to-GDP ratio in the long run, it must be that:
𝑇
𝐺 (𝑟 − 𝑔)𝐷
= +
𝑌
𝑌
𝑌

Fiscal policy in the short run:
When we include the government in our model of aggregate demand, production is given by:
𝑌= 𝐶+ 𝐼+ 𝐺
Where C represents private consumption, I represents private investment and G is government
expenditure on goods and services - that is, government consumption and investment
...
Real disposable income is:
𝑌 𝑑 = 𝑌 − 𝑇 + 𝑟𝐷
T represents the taxes that households pay to the government minus government transfers from the
government to households
...
We must also modify the consumption function derived in Chapter 4 to
account for taxation:
𝐶 = 𝐶(𝑌 − 𝑇, 𝑌 𝑒 − 𝑇 𝑒 , 𝑖 − 𝜋 𝑒 , 𝐴)
𝑇 𝑒 is the expected future level of taxation
...
In the short run, production is determined by
aggregate demand:
𝑌 = 𝐶(𝑌 − 𝑇, 𝑌 𝑒 − 𝑇 𝑒 , 𝑖 − 𝜋 𝑒 , 𝐴) + 𝐼(𝑖 − 𝜋 𝑒 , 𝑌 𝑒 , 𝐾) + 𝐺
To include a simple tax system in our model we assume that the government taxes all income at the
rate 𝜏 and at the same time it hands out a lump sum transfer Tr to households
...
As production increases, incomes increases, and this leads to further increases in
consumption through the multiplier effect
...

We can also calculate the short-run effect on production of an increase in transfers:
∆𝑌 =

𝑎₁
∆𝑇𝑟
(1 − 𝑎₁ + 𝑎₁𝜏)

We can see here that an increase in transfers will have a smaller effect on production than an
increase in government expenditure
...
However,
in practice interest rates are unlikely to remain constant; when the government increases
expenditure and boosts aggregate demand there is a possibility that a positive output gap will be
created and this will cause inflationary pressures
...

If this were to happen then production would return to the natural level and the result of the
government's action to increase expenditure will simply be an increase in the interest rate
...


Does cutting taxes really make us richer?
We can argue that a reduction in public sector saving will be met be an increase in private sector
saving and therefore in the long run production will not be increased
...
As taxes are expected to rise in the future consumers will save the additional income they
have as a result of the tax cut in order that they can pay the higher taxes in the future
...

Ricardian Equivalence makes the following assumptions:






The Absence of credit constraints, you can borrow whatever you want in a given period, i
...
If
you had knowledge of what your lifetime income would be then you could borrow this amount
in one go
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Consumers expect to pay the increased taxes in the future and are forward-looking
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As a result of these assumptions, which do not hold in the real world, there are some serious flaws
with Ricardian Equivalence - for example consumers may expect lower taxes will be paid for by lower
public expenditure or may be myopic and only care about the next 2/3 years
...
The increase/decrease in government spending/taxes will not be entirely offset by

the private sector
...
Imperfect Ricardian Equivalence implies that temporary tax cuts have
moderate impact on aggregate demand and that households understand to some extent that lower
taxes now, keeping G constant, will lead to higher taxes in the future
...

Temporarily higher government spending, financed by borrowing, increases aggregate demand in
the short run while the offsetting effect of higher debt on consumption (higher taxes in the future) is
spread over an entire lifetime
...
Recent studies suggest that the spending multiplier is
approximately 1 , the investment multiplier is 1
...
60
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Fiscal Policy and the Business Cycle:
One of the biggest problems when trying to implement effective fiscal policy is the existence of time
lags
...

Information lag refers to the imperfect knowledge we have about the economy and how the
information that we do have often refers to a period a few months or years in the past
...

The implementation lag refers to the amount of time that it takes for policy to be implemented after
the decision is taken, for tax rates this can often be as much as a year as the government gives
businesses and consumers time to adapt to the changes
...

Automatic Stabilisers:






Changes in the primary balance that occur without the government making discretionary
budgetary decisions
...

If GDP increases by 1%, the budget improves by approximately 0
...
Although this may ignore the effect of people moving in to higher tax
bands
...


The Structural (or cyclically adjusted) budget:





This figure strips out the effect of automatic stabilisers
...

Assume that GDP is 4% below the potential level and the deficit is 8% of GDP
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5x4) that is, 6% of GDP
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Do governments stabilise the real economy? By running large deficits during recessions the
government can help to stabilise the economy but by running small deficits during expansionary

periods the government could also have a destabilising effect (it should be running a surplus to
prevent the economy from overheating and also to pay off the debt from previous recessions)
...
This is because the stabilising effect in a recession should be greater than the
destabilising effects during the expansionary periods
...
If the Central Bank raises interest rates,
crowding out is possible
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Economic policy and the ZLB
Suppose a very large negative demand shock hits the economy
...
However, this might still not stimulate
demand sufficiently
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If interest rates are at the ZLB and the central bank uses QE, this indicates that the central bank
would like to cut rates even further - this means that rates will stay low for a long time and the
chances of crowding out are greatly reduced
...
Moreover, new research shows that
the spending multiplier is far higher during recessions, perhaps this is due to a higher marginal
propensity to consume during these periods
...
This suggests that
during recessions Ricardian Equivalence is less likely to hold this is perhaps due to the assumptions
we made about the availability of credit, the lack of liquidity during recessions limits the ability of
the private sector to save
...
This means that the government's spending will have a
greater effect on the economy
...

Due to policy lags, conventional monetary policy is the preferable interest rate for stabilising the
economy during normal times
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If
conventional monetary policy is constrained, i
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Approaching the ZLB, discretionary fiscal policy
becomes very important - think about public work schemes
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Where a common currency such as the Euro is used, one member may be in recession
while the rest are growing strongly
...

When interest rates are near the ZLB, fiscal austerity can prolong and deepen recessions and
therefore a policy of gradual reduction by running no/small budget deficits may be preferable
...
The IMF has come up with the concept of fiscal space which is defined as the
difference between actual debt/GDP and the debt level at which debt dynamics become explosive
(e
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The debt limit)
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