Macroeconomics Chapter 13

Chapter 13: Fiscal Policy, Deficits, Surpluses, and Debt

Learning Objectives

• LO13.1 Identify the purposes, tools, and limitations of fiscal policy.

• LO13.2 Explain how built-in stabilizers moderate the business cycles.

• LO13.3 Describe how the cyclically adjusted budget reveals the status of Canadian fiscal policy.

• LO13.4 Summarize recent Canadian fiscal policy, focusing on significant events and measures.

• LO13.5 Discuss problems governments may encounter in enacting and applying fiscal policy, including theoretical and practical challenges.

• LO13.6 Discuss the size, composition, and consequences of Canadian public debt, including comparison with international standards.

13.1 Fiscal Policy and the AD-AS Model

Fiscal Policy Tools

Fiscal policy encompasses a variety of actions taken by government to influence economic activity, mainly through changes in government spending and taxes.

• Active Fiscal Policy: This consists of deliberate changes to government spending or taxes, which are often subject to political processes and can be influenced by current economic conditions and objectives.

• Non-discretionary Fiscal Policy: Also known as automatic stabilizers, this refers to changes in fiscal policy that occur automatically due to the existing laws and economic conditions, without the need for specific government action.

Impact of Aggregate Demand

• Decreasing aggregate demand (from AD1 to AD2) can lead to a significant reduction in real GDP when the price level does not adjust flexibly, which makes the economy susceptible to recessions.

• Expansionary Fiscal Policy plays a critical role in reversing this situation by increasing government spending or cutting taxes. For instance, a $5 billion increase in government expenditure can create a considerable rightward shift in aggregate demand, particularly when taking into account the multiplier effect, where a marginal propensity to consume (MPC) of 0.75 can lead to total demand increases of up to $20 billion.

Contractionary Fiscal Policy

• Implemented primarily to combat demand-pull inflation, this approach involves both reducing government spending and increasing taxes.

• For example, a strategic approach might involve cutting spending by $3 billion or raising taxes by $4 billion, effectively shifting aggregate demand leftward to counteract inflationary pressures.

Built-In Stabilizers

Function and Operations

Built-in stabilizers such as progressive taxation and unemployment benefits work to autonomously stabilize the economy.

• Taxation: As incomes rise, taxes automatically increase, which helps reduce budget deficits during economic booms.

• Transfer Payments: Conversely, during economic downturns, transfer payments such as unemployment benefits rise without further legislative action, providing a safety net for affected individuals and thereby stabilizing overall demand in the economy.

Evaluating Fiscal Policy

Cyclically Adjusted Budget

The cyclically adjusted budget serves as an essential tool for evaluating fiscal policy. It adjusts the actual deficits or surpluses based on changes in revenue that occur due to fluctuations in GDP, thus providing a clearer picture of the underlying fiscal stance when the economy is operating at full employment. This framework allows policymakers to assess whether current fiscal policy is expansionary or contractionary, distinct from temporary fluctuations.

Recent Canadian Fiscal Policy

Historical Context

Recent Canadian fiscal policy has seen a dramatic shift from a period of surpluses to significant deficits, particularly as a response to the unprecedented economic challenges posed by the COVID-19 pandemic, which resulted in the largest annual deficit since World War II. From 2003 to 2020, actual deficits varied notably, reflecting the government's greater engagement in stimulus measures, particularly notable during the 2009 recession and subsequent recovery efforts.

Problems and Complications in Implementing Fiscal Policy

Timing Issues

Implementing effective fiscal policy often encounters various timing issues:

• Recognition Lag: The time it takes for policymakers to recognize an economic issue has emerged.

• Administration Lag: The delays encountered in getting new policies approved and implemented.

• Operational Lag: The gap between the initiation of a policy measure and its economic impact.

Political Considerations

Policies may be influenced by political dynamics, which can lead to reversals or conflicting strategies between different branches of government or levels of administration. Tension may arise where one policy aimed at reducing debt may counteract another policy aimed at stimulating economic growth.

Crowding Out Effect

The crowding out effect occurs when expansionary fiscal policy, while intending to boost economic activity, leads to increased interest rates due to higher government borrowing. This can deter private investment spending, weakening the overall impact of the fiscal stimulus. Notably, during economic recessions, this effect may be less pronounced as monetary policy often accommodates fiscal measures more effectively.

Fiscal Policy in the Open Economy

External Shocks and Net Export Effects

In an interconnected global economy, external shocks, such as economic downturns in foreign markets, can significantly impact the effectiveness of local fiscal policies. Expansionary fiscal measures can elevate domestic interest rates, potentially leading to currency appreciation. This can adversely affect net exports, diluting the anticipated increase in aggregate demand from fiscal stimulus.

Deficits, Surpluses, and Federal Debt

Definitions

• Budget Surplus: A condition in which revenues exceed expenditures, providing an opportunity for the government to invest in future projects or reduce existing debt.

• Budget Deficit: Occurs when expenditures exceed revenues, necessitating borrowing to cover the gap.

• Public Debt: The cumulative total of all budget deficits, representing the net outstanding liabilities of the government.

Debt Ownership and Trends

Public debt includes various forms of government securities held by different sectors of the economy, including households, foreign investors, and institutional entities.

• Recent trends indicate that Canada maintained manageable levels of public debt compared to other G7 nations prior to the advent of the COVID-19 pandemic.

Conclusion

A comprehensive understanding of fiscal policy, its tools, and implications, the effectiveness of its evaluation methods, and challenges inherent in implementation is critical. Recognizing how these factors influence economic stability and growth lays the groundwork for informed fiscal decision-making and policy development.