Lecture 16 - Fiscal and Monetary Policy

UNDERSTANDING THE ECONOMY

FISCAL POLICY AND THE PUBLIC FINANCES

Definition of Fiscal Policy

  • Fiscal policy seeks to control aggregate demand by altering the balance between government spending and taxation.

Roles of Fiscal Policy

  • Correcting fundamental disequilibrium (for example, response to Covid-19).

  • Stabilization policies to influence aggregate supply.

Terminology in Government Finances

  • Government: The national administrative body.

  • Budget deficits: The financial situation where expenses exceed revenue.

  • Budget surpluses: The financial position where income is greater than expenditures.

  • General government deficit/surplus: A measure of the overall fiscal position of the government sector as a whole.

  • National debt: The total amount of money that a country's government has borrowed.

  • General government debt: The accumulated deficits of all levels of government that has yet to be paid.

  • Public sector: The part of the economy concerned with providing various governmental services.

  • Current and capital expenditure: Different categories of government spending, where current expenditure refers to operational costs and capital expenditure relates to investments in long-term assets.

  • Public-sector net borrowing and the PSNCR: The net amount of debt that the government needs to borrow.

  • Public-sector net debt: The total amount of money owed by the government sector net of its financial assets.

Key Fiscal Indicators and Sustainability of Public Finances

  • Public-sector current budget surplus (or deficit): It compares current revenues and expenditures.

  • Primary surplus (or deficit): It relates to government revenue minus all expenditure except interest payments on national debt.

  • Debt sustainability rule: A guideline on the maintainable levels of government debt in relation to GDP and interest payments.

Illustrative Data

  • Data related to general government deficits/surpluses and debt as a percentage of GDP can indicate fiscal health and fiscal policies' effectiveness.

Fiscal Policy Challenges During Economic Events

  • The impact of large expansions of government spending (denoted as G), declines in revenue (denoted as T), and consequent rises in borrowing during significant economic downturns (for example, the Covid-19 pandemic).

THE USE OF FISCAL POLICY

Automatic Fiscal Stabilizers

  • Tax stabilizers: Automatic changes in tax liabilities with changes in income.

  • Benefits stabilizers: Adjustments of welfare benefits to reflect changes in economic circumstances, which help stabilize disposable income.

Effectiveness of Automatic Stabilizers

  • Automatic stabilizers often have adverse supply-side effects but are beneficial in stabilizing demand.

  • The problem of fiscal drag occurs when inflation pushes taxpayers into higher income brackets, thus increasing tax burdens without legislative changes.

Discretionary Fiscal Policy

  • Refers to deliberate changes in fiscal measures aimed at influencing economic activity directly.

  • Can include changing government spending (G) or altering tax rates (T).

Issues with Discretionary Policy

  • Problems exist in forecasting economic effects and understanding injections and withdrawals within the economy, potentially leading to crowding-out effects where increased public sector financing displaces private sector funding.

MONETARY POLICY

Overview of Monetary Policy

  • The setting of monetary policy includes decisions on the independence of central banks and controlling the money supply along with awareness of liquidity ratios within banks.

Long-term vs Short-term Control

  • Long-term control: Involves setting explicit inflation and growth targets.

  • Short-term control: Relates to adjusting interest rates and managing liquidity.

Techniques of Monetary Policy

  • Open-Market Operations (OMOs): Central bank activities to buy or sell government securities to control the money supply.

  • Adjusting statutory reserve ratios to banks, thereby influencing their ability to lend.

Problems with Monetary Policy

  • Difficulties in short-run control can arise from banks holding excess reserves, potentially leading to liquidity fluctuations and unstable interest rates.

POLICY-MAKING ENVIRONMENT

Evaluation of Rules vs Discretion in Fiscal and Monetary Policy

  • The case for rules: Reducing the risk of political influence that can inflate deficits for electoral gains.

  • The case for discretion: Flexibility in responding to rapid market changes, which is particularly crucial in volatile economic environments.

Inflation Targeting Globally

  • Various countries employ inflation targets to stabilize their economies, with specifics varying by country based on their economic contexts.

Issues with Inflation Targets

  • Debate over who sets targets, fluidity in changing targets, and complexity in aligning multiple targets are critical considerations in formulating effective monetary policy.

LONG-TERM ECONOMIC GROWTH AND SUPPLY-SIDE POLICIES

Objectives of Supply-side Policies

  • Aimed at enhancing long-term economic growth through:

    • Technological advancements.

    • Workforce education and training.

    • Addressing labor market imperfections.

Market-based Approaches to Supply-side Policy

  • Tactics include reducing government spending and incentivizing competition via privatization and deregulation.

    • Emphasis on increasing market relationships, encouraging innovation, and enhancing productivity is required.

Economic Growth Data (Historical Context)

  • Analysis of growth rates across various countries from 1960 to 2020 highlights comparative performance and boosts for productivity and employment-related factors, which involves policy responses to historical challenges like Covid-19.

Interventionist Policies

  • These arise in recognition of inherent market shortcomings and contain government investments in R&D and educational initiatives aimed at correcting market imbalances.

  • Specific examples include targeted assistance during depressions or crises to stimulate investment and innovation while assuaging regional disparities.

Summary of Policy Impacts

  • Successful supply-side policies can enhance economic capacity, ultimately driving long-term growth in the face of cyclical economic conditions. The careful balance between demand-side and supply-side measures is essential for sustainable economic health and development.