11. Fiscal policy

Not only can central banks use monetary policy to reduce fluctuations by adjusting the money supply, government can also help with Fiscal policy. What is Fical policy?

Fiscal policy: Government´s way of reducing economic fluctuations by adjusting taxes and government expenditures. (stimulate economic growth)

Expansionary fiscal policy

Uses higher government expenditures and lower taxes to increase growth rate real GDP and reduce unemployment.

Contractionary fiscal policy

In contrast, uses lower government expenditures and higher taxes to reduce growth rate of real GDP.

Automatic stabilizers

government spending and taxes that automatically increase or decrease along with the business cycle

Discretionary spending

When the government decides to take action such as cutting tax or spending more to help the economic fluctuations.

National accounting identity

Y = C + I + G + X - M

Expansionary fiscal policy: Government expenditures

- Increased expenditure directly increases output (Y)

- E.g: All else being equal, increasing G by SEK 1, results in an increase of Y by SEK 1

Reason for why increase in government expenses increase output

Increased government expenditures, boost demand for goods and service, meaning boosts the consumption which further increases firm profits, shifting labor demand curve to the right, and increases employment and reduces unemployment. Results: Increase in output.

Expansionary fiscal policy: government expenditures — multiplier effect

- Increasing government expenditures increase employment and output.

- E.g: If C increases also by SEK 1, then SEK 1 additional units of G result in SEK 2 additional units of Y

- Multiplier effect for government expenditures

Raising government expenditures leads to higher income and employment which increases demand for goods and services leading to increased consumption leading to higher firms profits and higher demand for labor, reducing unemployment - leading to even more output.

Expansionary fiscal policy: government expenditures — crowding-out

- As said before raising G increases employment and output, and the multiplier effect further raised output. However to raise these expenditures they need to borrow which leads to crowding out.

- E.g: If I decreases by SEK 1, then SEK 1 additional units of G result in SEK 1 additional units of Y

Crowding out for investors and firms

- Crowding out: When government borrows more to fund its expenditures it will increase the demand for credit which push the interest rates up. At the same time it the higher interest rates will make it more expensive for private investors to borrow so the credit demand declines. As a result the government has crowded out the private investors leading to a decline in investment.

- For firms its expensive to borrow due to the higher interest rates, which decreases demand for labor shifting it to left, employment declines, unemployment increases leading to output declines.

Government expenditure multiplier

Says by how much output increases if government expenditures increase by one unit.

- Divide changes in output with changes in government expenditures.

- Usually m is between 0 and 1.5

- M is typically high in recession and low during expansions

The expansionary fiscal policy for government expenditures multiplier graphical

This pictures illustrates if the economy is on a trough meaning their lowest point in a recession before it will recover, the government will implement a fiscal policy to reduce this fluctuation or recession and stimulate economic growth by increasing government expenditures and reducing taxes (expansionary). However increasing G will lead to a multiplier effect, not only increasing the output but also the consumption increasing the output even more, increasing the demand for consumption shifting to right. However higher expenditures means higher loans for government, increasing credit demand shifting right and leading to higher interest rate, this affect private investors negatively since it is too expensive so their demand shifts left leading to same place for the demand curve. Resulting in a small change called the partial recovery. Less investment.

Government debt

Varies across developed economies and has generally been increasing. It represents the liabilities of the public sector.

Expansionary fiscal policy: taxation

- Reducing taxes will lead to increase in consumption and even more due to multiplier effect, but this will lead to a crowding out on investment, increasing consumption but less saving. The crowding out effects net-exports leading to more consumption on imported goods. Output can either increase or decrease, usually positive.

Ways to measure government debt:

- Nominal debt vs debt-to-gdp ratio

- Unified deficit VS at different levels

- Internal VS external debt

Nominal debt

Total amount the government owes.

Debt-to-GDP ratio

the government's debt as a percentage of GDP

Unified deficit

Overall budget deficit for the entire government combining all levels (federal, state, local).

Deficits at different levels

These are budget deficits specific to different levels of government.

internal debt vs external debt

Internal Debt: Debt government owes to its own citizens or institutions.

External debt: Debt government owes to foreign lenders or institutions.

The limit to government debt is influenced by:

- Increase in Future primary surpluses

- Decreases in Interest rates

- Increasing in GDP growth

- Whether government repay or not is uncertain but the Investors expectations matter

Primary surplus

Government revenue (taxes) - spendings. Meaning they bring in more money than spending.

What did history teach us about government limit?

Limit government debt was crossed several times.

Key point

If a country is above the limit it will continue have a debt over it, same with if they are below the limit they will continue be below.