Lecture 15: Stabilisation Policy

Dr Bhaskar Chakravorty

Warwick University

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Stabilisation policy
This topic

▶ Unconventional Monetary Policy (basic discussion)

▶ Government Spending & Revenues

▶ Fiscal policy

▶ Government debt & debt dynamics

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Monetary Policy

▶ Changes in interest rate

▶ In large economies the main transmission channel goes through

investments
▶ In smaller economies, the exchange rate is a very important channel
▶ International investors want to hold and trade financial assets from
around the world
▶ Higher returns (higher interest rates) attract more investors
decrease of policy rate - decrease in demand for that country’s bonds
demand for the currency declines - depreciation of the currency
exports become cheaper (imports become more expensive)

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Monetary Policy

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Stabilisation policy

▶ Monetary policy is the favourite stabilisation tool

▶ Fiscal policy takes time to implement and less flexible
▶ Interest rates can be changed every few months
▶ To stabilise the economy is not an easy task
The CB is not always able to accurately diagnose a shock
▶ Limitations of Monetary Policy?
▶ Zero lower bound
▶ (a country without its own currency - not for this course!)

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Stabilisation policy
MP after the financial crisis

▶ influence expected inflation

▶ Quantitative easing

▶ Negative interest rates

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Stabilisation policy
MP: Quantitative easing

▶ CBs purchases of financial assets

▶ Aim to increase AD by buying these assets, even when rates are zero

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Stabilisation policy
MP: Negative interest rates

▶ Some CBs lower interest rates into negative territory

▶ Aim to lower real interest rates and to affect inflation expectations

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Fiscal policy

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Fiscal Policy
Government spending

▶ general government consumption and investment

▶ includes spending by both local and central government on goods

and services. approx 20% of GDP in the UK
▶ an increase in government spending increases aggregate demand

▶ government spending is usually stable

(it does not fluctuate with capacity utilisation or move with business
confidence)

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Fiscal Policy
Government revenues

▶ The government raises taxes from the economy (income tax, tax on
spending, taxes on goods)
T = Taxation revenues -Transfers
▶ transfer payments: have an indirect effect on aggregate demand
(through taxation)
▶ unemployment benefits
▶ state pensions

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Fiscal Policy

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Fiscal Policy

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Fiscal Policy

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Fiscal Policy
Scope

▶ Income redistribution (using taxes and transfer systems)

▶ Resource allocation (e.g. subsidies/taxes to particular industries)

▶ Provision of public goods (non-excludable and non-rivalrous goods

which are not provided bythe market)

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Fiscal Policy
Role of fiscal policy as stabilisation policy

▶ Discretionary fiscal policy: used when monetary policy becomes

ineffective
▶ Automatic stabilisers: AD shock insulation (even in the absence of
discretionary FP)
▶ Fiscal policy affects public debt: downsides of using discretionary FP

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Discretionary fiscal policy

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Fiscal Policy
How effective is discretionary fiscal policy?

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Fiscal Policy
A negative demand shock (deflation trap)

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Fiscal Policy
An ambitious government targeting output above equilibrium (inflation bias)

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Fiscal Policy
The fiscal multiplier

▶ Full multiplier effect depends on the model, context and CB

behaviour
▶ If there is spare capacity, government can boost AD and output to
improve welfare
▶ If y = ye, expansionary FP will lead to higher inflation and
government debt, while output willstay unchanged in the new
equilibrium

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Fiscal Policy
The fiscal multiplier: fully tax-financed expenditure programme

▶ The balanced budget multiplier depends on equal marginal

propensity to consume for taxpayers and providers of goods and
services
▶ In this case, spending power is redistributed from taxpayers to the
providers of goods and services
▶ Aggregate consumption remains unchanged, and the only impact on
y is the initial ∆G

▶ Balanced budget expenditure may be useful if government wants to

boost AD in a recession and is unable/ unwilling to use debt
financing

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Fiscal Policy
The fiscal multiplier: fully tax-financed expenditure programme

▶ Empirical studies: No firm consensus on multiplier size;

Difficult to isolate ∆G’s effect from other factors
▶ Size depends on context
larger multiplier in developed countries, closed economy, fixed
exchange rates regimes. Negative multiplier in high debt countries
▶ In our 3-equation model: fiscal policy can be used to boost AD and
return economy to equilibrium in a recession, especially when the
ZLB is hit

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Fiscal policy:Automatic stabilisers

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Fiscal Policy
The fiscal multiplier: Automatic stabilisers

▶ Automatic stabilisers offset fluctuations in economic activity without

direct intervention ofpolicy authority
▶ When AD is high (income is high), tax revenue increases and
government benefits fall (due to a decrease in eligibility)
▶ Automatic stabilisers will affect the government primary budget

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Fiscal Policy

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Quiz

▶ Assume that a government has a balanced primary budget when the

economy is at its equilibrium level of unemployment. If the economy
enters a recession, with no change in tax or spending policy, then
the primary budget is more likely to:
▶ remain balanced
▶ be in deficit
▶ be in surplus

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Fiscal Policy: Debt Dynamics

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Debt sustainability: sovereign default risk

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Ricardian equivalence and PIH

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Quiz

The primary budget is balanced. The interest rate is 5%. The growth
rate of GDP is2%. The initial debt-GDP ratio is 10%. Over time, the
debt to GDP ratio will grow by:
▶ 2%
▶ 3%
▶ 5%
▶ 10%

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Stabilisation Policy
References

Carlin and Soskice’s textbook - Chapter 14

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