Economics for Business - Lecture 9: Fiscal and Monetary Policy

Fiscal Policy

Fiscal Policy and Public Finances

• Fiscal policy seeks to control aggregate demand by:

  • Altering the balance between government spending (injection into the circular flow of income) and taxation (withdrawal).

• Roles for fiscal policy:

  • Correcting a fundamental disequilibrium.

  • Implementing stabilization policies.

  • Influencing aggregate supply.

Correcting a Fundamental Disequilibrium

• Use expansionary fiscal policy to prevent prolonged recession (e.g., Great Depression):

  • Raise government expenditure or cut taxes to boost the economy.

• During a boom:

  • Reduce government expenditure or raise taxes to dampen expansion and avoid overheating.

Stabilization Policies

• Successful stabilization policies amount to "fine-tuning."

  • Problems of excess or deficiencies in demand are not allowed to become severe.

Influencing Aggregate Supply

• Increase government expenditure on infrastructure.

• Provide tax incentives for investment.

Government Finances Terminology

• Budget Deficit: The excess of central government’s spending over its tax receipts.

• Budget Surplus: The excess of central government’s tax receipts over its spending.

• General Government Deficit (or Surplus): The combined deficit (or surplus) of central and local government.

• National Debt: The accumulated budget deficits (less surpluses) over the years, representing the total amount of government borrowing.

Public Sector Finances

• Public Sector:

  • Current and capital expenditure.

  • Final expenditure and transfers.

  • Public-sector net borrowing and the PSNCR (Public Sector Net Cash Requirement).

  • Public-sector net debt.

• Current Expenditure: Recurring spending on goods and factor payments.

• Capital Expenditure: Investment expenditure; expenditure on assets.

• Final Expenditure: Expenditure on goods and services included in GDP and part of aggregate demand.

• Transfers: Transfers of money from taxpayers to recipients of benefits and subsidies.

• PSNCR: The annual deficit of the public sector, which indicates the amount the public sector must borrow.

National Income and Public Sector Deficit/Surplus

• When the economy is performing well:

  • Unemployment decreases, reducing government spending on benefits.

  • Tax revenue increases.

• When the economy is not performing well:

  • Unemployment increases, increasing government spending on benefits.

  • Tax revenue decreases.

Business Cycle and Public Finances

• Fiscal Stance: Refers to whether a government is pursuing an expansionary or contractionary fiscal policy.

• Whether the economy expands or contracts depends on the balance of total injections and total withdrawals.

• If the deficit this year is lower than last year, aggregate demand this year is also lower than last year because government expenditure may have fallen or tax revenue may have increased.

• Booming economies:

  • High amount of tax paid.

  • Lower demand for benefits, leading to a public sector surplus (or a reduced deficit).

• Depressed economies:

  • Low amount of tax paid.

  • Higher demand for benefits, leading to a high public sector deficit.

The Use of Fiscal Policy

• Governments have two types of fiscal instruments:

  • Automatic Fiscal Stabilizers (non-discretionary):

    • Tax revenues that rise and government expenditure that falls as national income rises.

    • They act as a built-in mechanism, stabilizing the business cycle and reducing the size of the multiplier.

  • Discretionary Fiscal Policy:

    • Deliberate changes in tax rates or the level of government expenditure to influence aggregate demand.

Automatic Fiscal Stabilizers and Effectiveness

• Automatic stabilizers act instantly when aggregate demand fluctuates.

• Discretionary changes in taxes or government expenditure may take time to institute.

  • Tax Stabilizers: Tax rises mean a higher marginal propensity to tax (MPT), leading to a smaller multiplier and a greater stabilizing effect.

  • Benefits Stabilizers: Benefits fall means more tax revenue, thus a higher MPT, leading to a smaller multiplier and a greater stabilizing effect.

Effectiveness of Automatic Stabilizers - Adverse Supply-Side Effects

• High tax rates may discourage effort and initiative.

  • The higher the MPT, the better the stabilizing effect but there may also be a disincentive for workers.

• High unemployment benefits may increase equilibrium unemployment.

  • High unemployment benefits may cause people to take longer to look for a job.

• Poverty Trap: Occurs if benefits of unemployment are better than a low-earning job.

Fiscal Drag

• Automatic stabilizers help to reduce upward and downward movements in national income.

• Fiscal drag is the tendency of automatic stabilizers to reduce the recovery of an economy from recession.

Discretionary Fiscal Policy

• Deliberate changes in fiscal policy to influence aggregate demand because automatic stabilizers do not stop fluctuations, but merely reduce them.

• Other purposes of discretionary fiscal policy include:

  • Altering aggregate supply (e.g., tax incentives to encourage people to work more).

  • Altering the distribution of income (e.g., tax the rich, provide benefits to the poor).

Implementing Discretionary Fiscal Policy

• Changing Government Spending (G):

  • If government expenditure on goods and services is raised (e.g., by £100 million), it will create a multiplied rise in national income because all the money gets spent and boosts aggregate demand.

• Changing Taxes (T):

  • If taxes are cut (e.g., by £100 million), it will have a smaller multiplied effect than government spending because only a part of people's disposable income will be spent.

  • More tax cuts are needed to achieve the same multiplied effect as government spending.

Problems of Forecasting the Magnitude of the Effect

• Effects on other injections and withdrawals:

  • It is difficult to know how much government spending has increased aggregate demand, given it may affect other components in the AD model (e.g., private spending).

• Crowding Out:

  • If the government uses purely fiscal policy (i.e., policy that does not involve a change in money supply), it will borrow money from the non-bank private sector, competing with the private sector for finance and leading to higher interest rates.

• Size of the Multiplier and Accelerator Effects:

  • It is difficult to measure the multiplier effect as the marginal propensity to consume (MPC) and marginal propensity to withdraw (MPW) fluctuate due to many factors (e.g., future expectations on income and prices).

• Random Shocks:

  • Forecasts cannot take into effect unpredictable events (e.g., September 11, 2001).

Problems of Timing and Time Lags

• Fiscal policies could involve considerable time lags therefore can be destabilizing.

• For example, an expansionary policy taken to cure recession may not come into effect until the economy has already recovered and is experiencing a boom.

• Under these circumstances, expansionary policies are inappropriate and can worsen the problem of overheating (where productive capacity is unable to keep pace with growing aggregate demand).

Fiscal Policy: Stabilizing or Destabilizing

• Path (a) shows the course of the business cycle without government intervention.

• Ideally, with no time lag, the economy should be dampened in stage 2 and stimulated in stage 4, making the resulting business cycle as in

  • Path (b) or even a straight line if the policies were perfectly stabilizing.

• With time lags however, contractionary policies taken in stage 2 may not come into effect until stage 4, and expansionary policies taken in stage 4 may not come into effect until stage 2. In this case, the resulting business cycle would be more like

  • Path (c).

Monetary Policy

• Money supply is controlled through monetary policy.

• Monetary policy seeks to control aggregate demand by directly controlling the money supply or by altering the rate of interest and then backing this up by any necessary changes in money supply.

• Monetary policy is a set of actions taken by the central bank in order to affect the money supply.

• A central bank has the following tools (discussed in money and banking):

  • Open-market operations

  • Changing the refinancing rate

  • Changing the reserve requirement (minimum reserve ratio)

Issues on Controlling Money Supply

• A central bank’s control of the money supply is not precise.

• A central bank must wrestle with two problems that arise due to fractional-reserve banking:

  • The central bank does not control the amount of money that households choose to hold as deposits in banks.

  • The central bank does not control the amount of money that bankers choose to lend.

Interest Rates

• Interest is the cost of borrowing money and it is the price that an individual or organization is charged to be given a loan.

• An interest rate tells you how quickly those borrowing costs will accumulate over time.

  • For example, if someone gives you a one-year loan of £100 with a 10% interest rate, you'd owe them £110 back after 12 months.

Controlling Interest Rates - THE ROLE OF CENTRAL BANKS

• The central bank controls the interest rates in the economy.

• The main monetary approached used in many countries today focus directly on interest rate.

• Interest rates affect the certainty among businesses and thus affect long term investment and growth in an economy.

How to Control Interest Rates

• An interest rate is announced, and then the central bank will conduct an open market operation to ensure that the supply of money is adjusted to make the announced interest rate the equilibrium one.

• Changing the money supply can alter the interest rate and helps get the desired interest rate.

• A central bank looks to affect the real interest rates through their monetary operations that affect the nominal interest rates.

• If inflationary expectations are constant, then announcing a particular change in nominal rates will have an equivalent change on the real interest rates.

• The demand for money and supply of money can be graphed to determine the equilibrium interest rate.

• The equilibrium interest rate is the rate of interest at which the quantity of money demanded is equal to the quantity of money supplied.

Raising Interest Rates

• The central bank generally will seek to keep bank short of liquidity.

• This shortage can be used as a way of forcing through interest rate changes.

• Banks will obtain the necessary liquidity from the central bank.

• If the central bank decides to raise interest rate, the central bank can choose the rate of interest to charge.

• This will then have a knock-on effect on other interest rates throughout the banking system.

Issues - Controlling Interest Rates

• Problem of an inelastic demand for loans:

  • If the demand for loans is inelastic, any attempt to reduce the demand will involve large rise in interest rates.

  • The problem will be compounded if the demand curve shifts to the right, due to a consumer spending boom.

Problems with High Interest Rates

• They may discourage long-term investment (as opposed to current consumption) and hence affect long-term growth.

• They add to the costs of production, to the costs of house purchase and generally to the cost of living; thus, cost inflationary.

• They are politically unpopular, since the general public do not like paying higher interest rates on overdrafts, credit cards and mortgages.