Fiscal Policy

Gaurav Khullar 244 Harshit Ajmera 238 Srishti Tekriwal 212 Shivani Khullar 243 Ashutosh Goel 263 Gaurav Joshi 219

Flow of presentation
Introduction Latest fiscal expenditure and revenue Major economic variables Classical theory New classical view of fiscal policy Keynesian view of fiscal policy Two cases

What is Fiscal Policy?

Fiscal policy is the deliberate manipulation of government purchases, transfer payments, taxes, and borrowing in order to influence macroeconomic variables such as employment, the price level, and the level of GDP

Government in the Economy

Discretionary fiscal policy refers to deliberate changes in taxes or spending. The government can not control certain aspects of the economy related to fiscal policy. For example:
The government can control tax rates but not tax revenue. Tax revenue depends on household income and the size of corporate profits. Government spending depends on government decisions and the state of the economy.

Budget
Budget is a financial plan and list of all planned and forecasted expenses and revenues.

I must be cruel only to be kind

Fiscal Deficit
When a governments total expenditure exceeds the revenue that it generates (excluding money from borrowings). Fiscal deficit was 5.9% of GDP for the year 2011-2012, and is expected to be 5.3% in 2012 - 2013

FDI and FII are said to be the expected reason for reduction in fiscal deficit as these are not just optional but imperative too.

Revenues
By 2009-10, direct taxes were contributing around 48 percent of revenues while the indirect taxes share was about 32 percent. In 2011-12, the share of direct taxes was about 47 percent while the indirect taxes contribution was around 37 percent.

2011-2012 Revenue

16%

47%

Direct Tax Indirect Tax Non Tax Revenue

37%

Expenditures
In 2009-10, defence expenditures made up around 10 percent, subsidies 16 percent and interest 23 percent of revenue expenditures. The situation remained more or less the same in the Budget of 2011-12, revealing once again the largely slow changing nature of the composition of government expenditures. In 2011-12, defence constitutes 9 percent, subsidies 13 percent and interest 24 percent.

2011-2012 Expenditure
9% Defence 24% 54% Interest Subsides Other Revenue Expenditure 13%

2012 13 Revenue and Expenditure Estimate

Taxes are expected to contribute close to 78% to the total revenues of the government in 2012-13. On an optimistic note the government has estimated a little over 20% increase in Net tax revenue

Total expenditure is estimated to record an annual growth of 10.1% to Rs. 1,490,925 Cr. Non planned expenditures to be 65% and planned expenditure to be 35%

Six Key Economic Variables

Six Key Economic Variables

The key indicators in macroeconomics are
real GDP the unemployment rate the inflation rate the interest rate the level of the stock market the exchange rate

Real Gross Domestic Product (GDP)

Is corrected for changes in the price level (real) Includes the replacement of worn-out and obsolete equipment and structures as well as new investment (gross) Counts economic activity that happens in the United States (domestic) Represents the production of final goods and services (product)

Real Gross Domestic Product

Often divided by the number of workers in the economy Measures how well the economy produces goods and services that people find useful Does not indicate the relative distribution of the nations economic product Is an imperfect measure of economic wellbeing

Real GDP Growth Rate

Six Key Economic Variables

The Unemployment Rate
to be unemployed, a person must want to work and be actively looking for a job (but have not yet found one) the labor force consists of those who are employed and those who are unemployed the unemployment rate is equal to the number of unemployed people divided by the labor force

Six Key Economic Variables

The Unemployment Rate
frictional unemployment occurs because workers and firms spend time searching for the best match cyclical unemployment occurs during recessions and depressions the unemployment rate is the best indicator of how well the economy is doing relative to its productive potential

New report by Labour Bureau

The female unemployment rate is estimated to be 12.5 per cent in urban areas and 5.6 per cent in rural areas. Similar rates of unemployment for males work out to be 3.4 per cent in urban areas and 2.7 per cent in rural areas. The unemployment rate is estimated to be 3.8 per cent at All India level.

Six Key Economic Variables

The Inflation Rate
is a measure of how fast the overall price level is rising Hyperinflation occurs when the price level is rising by more than 20% per month

Current Inflation in India

Annual inflation rate based on general CPI(Combined) for September 2012 is 9.73% as compared to 10.03 % for the previous month of August 2012. (point to point basis). Headline WPI inflation remained sticky at above 7.5 per cent on a y-o-y basis through the first half of 2012-13.

Six Key Economic Variables

The Interest Rate
is important because it governs the redistribution of purchasing power across time the many different interest rates in the economy vary by duration and degree of risk
often move up and down together

Six Key Economic Variables

The Interest Rate
nominal interest rate is the interest rate in terms of money
does not take into account the effects of inflation

real interest rate is the interest rate in terms of goods and services
does take into account the effects of inflation

Interest Rates In India

Repo rate : 8% Reverse Repo rate : 7%

Six Key Economic Variables

The Stock Market
is heard about most often (every day) is an index of expectations for the future
a high value means that investors expect economic growth to be rapid, profits to be high, and unemployment to be low

Sensex Index since 2008

Currently Sensex index is at 18,755.45

Six Key Economic Variables

The Exchange Rate
governs the terms on which international trade and investment take place nominal exchange rate is the rate at which moneys of different countries can be exchanged for one another real exchange rate is the rate at which the goods and services produced in different countries can be exchanged for one another

Six Key Economic Variables

The Exchange Rate
if domestic currency appreciates
its value in terms of other currencies increases foreign-produced goods are relatively cheap for domestic buyers
imports are likely to be high

domestic-made goods are relatively expensive for foreigners

exports are likely to be low

Six Key Economic Variables

The Exchange Rate
if domestic currency depreciates
its value in terms of other currencies declines domestic-produced goods are relatively cheap for foreign buyers
exports are likely to be high

foreign-made goods are relatively expensive for domestic buyers

imports are likely to be low

USD INR Exchange Rate

Presently, 1 dollar = 53.18 INR

Theories of Fiscal Policy

OVERVIEW OF CLASSICAL THEORY

Classical Economics- term invented by Karl Marx. The main tenet of classical economic theory is that if wages and price are flexible, there is a built in arrangement in the economy that makes it function at full employment. Classical theory took full employment for granted. It was, therefore, concerned primarily with alternate uses of a given quantity of employment resources.

If more resources were employed in one industry, they were drawn away from other firm.
Thus, choice in classical theory was employment here and employment there, and not between employment and unemployment.

ASSUMPTIONS IN CLASSICAL THEORY

There were basically two assumptions:
There can never be deficiency of aggregate demand. Products are paid with products, i.e., Supply creates its own demand . (SAYS Law) Wage rates are not sticky in nature and the operation of free market price system automatically removes unemployment which may occur temporarily.

SAYS LAW- ASSUMPTIONS

Three assumptions: Average propensity to consume= 1.
Government does not perform any economic function A closed economy.

Thus, economy under consideration is two sector economy. There is circular flow of money from firms to households and from households to firms. National income= national spending.

SAVINGS AND CLASSICAL ADJUSTMENT MECHANISM

S= saving C= consumption Y= income of households
Earlier, average propensity to consume=1 But due to savings, S= Y-C This means average propensity to consume decreases. Leads to over- production, hence profits of the producers will fall.

SAVINGS AND CLASSICAL ADJUSTMENT MECHANISM

But according to classical theory, each rupee saved will be invested (two sector economy).
The savings of households are passed on to banks, and firms borrow these funds for making investments on plant, equipment and other productive assets (in short, other productive goods).

Classical economists argued that amount invested will exactly equal the amount saved and thus, all income will be spent (partly on consumption goods and partly on investment goods).

Equality between Savings and Investments

Savings and classical adjustment analysis does not give a clear idea as to how investments equals savings (savings can be different from investments)
In classical theory, flexibility in rate of interest is the mechanism which maintains the equality between saving and investment so as to ensure full use of resources.

Flexible Prices and Wages and Automatic Adjustment Process

Any possibility of involuntary unemployment was ruled out in classical scheme on assumption of flexibility in

prices and wage rate.

In this situation, there would be competition for jobs, pulling down the wage rate. The wage rates would continue to fall till a point is reached where everyone who really wanted to work could get a job.
Thus flexibility in wage rates and prices provides an automatic adjustment process that ensures maintenance of full employment level in the economy.

Keynes's Criticism of Classical Theory of Full Employment

Keyness argument was on the following:There is no assurance that intended saving will equal intended investment at a level ensuring full employment. According to Keynes, the crucial determinant of saving is not the interest rate but rather the level of disposable income. Prices and wages are flexible is unrealistic. In the real world, there are a large number of monopolistic and oligopolistic firms operating and they effectively prevent any declining trends in prices. According to Keynes, manipulation of demand is a far more effective way to increase employment rather than manipulation of wage rate.

The New Classical View of Fiscal Policy

The New Classical View of Fiscal Policy

The New Classical view stresses that:

debt financing merely substitutes higher future taxes for lower current taxes, and thus, budget deficits affect the timing of taxes, but not their magnitude.
New Classical economists argue that when debt is substituted for taxes:

people save the increased income so they will be able to pay the higher future taxes, thus, the budget deficit does not stimulate aggregate demand.

The New Classical View of Fiscal Policy

Similarly, New Classical economists believe that the real interest rate is unaffected by deficits as people save more in order to pay the higher future taxes. Further, they believe fiscal policy is completely impotent that it does not affect output, employment, or real interest rates.

Expansionary Fiscal Policy

New Classical economists emphasize that budget deficits merely substitute future taxes for current taxes. If households did not anticipate the higher future taxes, aggregate demand would increase (from AD1 to AD2). However, when households fully anticipate the future taxes and save for them, demand remains unchanged at AD1.

Expansionary Fiscal Policy

To finance the budget deficit, the government borrows from the loanable funds market, increasing the demand (to D2). Under the new classical view, people save to pay expected higher future taxes (raising the supply of loanable funds to S2.) This permits the government to borrow the funds to finance the deficit without pushing up the interest rate.

Automatic Stabilizers
Automatic Stabilizers: Without any new legislative action, they tend to increase the budget deficit (or reduce the surplus) during a recession and increase the surplus (or reduce the deficit) during an economic boom. The major advantage of automatic stabilizers is that they institute counter-cyclical fiscal policy without the delays associated with legislative action. Examples of automatic stabilizers: Unemployment compensation Corporate profit tax A progressive income tax

The Keynesian View of Fiscal Policy

The Keynesian View of Fiscal Policy

Keynesian theory highlights the potential of fiscal policy as a tool capable of reducing fluctuations in aggregate demand. Following the Great Depression, Keynesians challenged the view that governments should always balance their budget. Rather than balancing their budget annually, Keynesians argue that counter-cyclical policy should be used to offset fluctuations in aggregate demand. This implies that the government should plan budget deficits when the economy is weak and budget surpluses when strong demand threatens to cause inflation.

Keynesian Policy to Combat Recession

When an economy is operating below its potential output, the Keynesian model suggests that the government should institute expansionary fiscal policy, by:
increasing the governments purchases of goods & services, and/or, cutting taxes.

Expansionary Fiscal Policy

At e1 (Y1), the economy is below its potential capacity YF . There are 2 routes to long-run full-employment equilibrium: Wait for lower wages and resource prices to reduce costs, increase supply to SRAS2 and restore equilibrium to E3, at YF. Alternatively, expansionary fiscal policy could stimulate AD (shift to AD2) and guide the economy back to E2, at YF .

Keynesian Policy To Combat Inflation

When inflation is a potential problem, Keynesian analysis suggests a shift toward a more restrictive fiscal policy by:
reducing government spending, and/or, raising taxes.

Restrictive Fiscal Policy

Strong demand such as AD1 will temporarily lead to an output rate beyond the economys long-run potential YF. If maintained, the strong demand will lead to the long-run equilibrium E3 at a higher price level (SRAS shifts to SRAS2). Restrictive fiscal policy could reduce demand to AD2 (or keep AD from shifting to AD1 initially) and lead to equilibrium E2.

Fiscal Policy and the Crowding-out Effect

The Crowding-out Effect

The Crowding-out effect

Indicates that the increased borrowing to finance a budget deficit will push real interest rates up and thereby retard private spending, reducing the stimulus effect of expansionary fiscal policy.
The implications of the crowding-out analysis are symmetrical.

Restrictive fiscal policy will reduce real interest rates and "crowd in" private spending.

Crowding-out effect in an open economy:

Larger budget deficits and higher real interest rates lead to an inflow of capital, appreciation in the dollar, and a decline in net exports.

Crowding-Out in an Open Economy

An increase in government borrowing to finance an enlarged budget deficit places upward pressure on real interest rates. This retards private investment and Aggregate Demand. In an open economy, high interest rates attract foreign capital. As foreigners buy more dollars to buy U.S. bonds and other financial assets, the dollar appreciates. The appreciation of the dollar causes net exports to fall. Thus, the larger deficits and higher interest rates trigger reductions in both private investment and net exports, which limit the expansionary impact of a budget deficit.

Case Study: Savings and Loan (S&L) Crisis in the US (1980s Case Study: Savings and 1990s)

Loan (S&L) Crisis in the US (1980s1990s)

The Situation
The Savings and Loans (S&L) Crisis of the 1980s and 1990s was a massive collapse of the thrift industry. S&Ls financed long-term fixed-rate residential mortgages with savings and time deposits at a restricted interest rate. When inflation rose in the 1970s, it exposed S&Ls to considerable interest rate risk and monetary policy was tightened.

Inflation in US from 1970 to 2007

Source: Fiscal Affairs and Research Departments, IMF

The Situation (contd)

S&Ls experienced enormous losses of net worth in 197982 and the early 1980s recession exacerbated the problem. The resulting slowdown in the finance industry and the real estate market may have contributed to the 1990 91 recession.

However the recession was short lived and relatively mild as the position of households and non-financial corporations was strong compared to other countries.

Government Intervention
The government intervened to restore stability of the financial sector but no traditional fiscal stimulus was implemented as concerns about rapidly rising public debt prevailed:

Source: Fiscal Affairs and Research Departments, IMF

Government Intervention (contd)

Initial government response to the crisis was slow and inadequate.

The government introduced measures such as expanding assets and liabilities power of S&Ls and granting permission for acquiring troubled S&Ls.
These changes aggravated the problem because under-capitalized S&Ls had incentives to invest in very risky projects, betting for survival.

Final Solution
The Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) narrowed the role of S&Ls and made them subject to more stringent capital requirements and regulatory scrutiny. Net government cost was reduced by involving the private sector through equity partnerships which made them share the deficit after the S&Ls assets were sold off. The net fiscal cost of the S&L clean up, contributing to fiscal deficits, is estimated at $124 billion (2.4% of GDP).

Lessons from S&L Crisis

Delay in resolution of problem led to higher costs, which may have been avoided. The equity partnerships with the private sector proved a good solution, especially for insolvent institutions. This bailout may have encouraged lenders to give high risk loans during the sub-prime crisis later which shows that measures should be designed keeping the future implications in mind.

KOREA
The economic crisis in 1997

KOREA: The economic crisis in 1997

The 1997 Korean crises had its roots in vulnerabilities in both the corporate and financial sector balance sheets. The debt/equity ratio of the thirty major largest companies was 500 percent The profitability of the corporate sector was weak, in part, due to over investment; and substantial currency and maturity mismatches of bank assets and liabilities. Short-term foreign borrowings (in foreign currency) were used to extend long-term loans (in domestic currency).

Debt/Equity Ratio in Manufacturing Sector

Parameters US 1997 Japan 1997 Taiwan 1995 Korea 1997 Korea 1997

Debt/Equity Ratio

153.5

193.2

85.17

396.3

303

Total borrowing & bond payable to total assets

25.6

33.1

26.2

54.2

50.8

In late 1997, Korean banks could not roll over short-term loans, despite the announced government guarantees for foreign debt. The Japanese banks, which were suffering from their growing NPLs, withdrew a large percentage of their loans. Foreign loans to Korea by Japanese financial institutions dropped from USD22 billion at the end of 1996 to USD9 billion by the end of 1997. The inability to roll over foreign loans triggered runs on the currency and the Korean won depreciated 25 percent in late November from its pre-crisis level. Currency market intervention left less than USD6 billion in usable foreign exchange reserves in December. By early 1998, most commercial banks and other financial institutions were technically in default due to the severe depreciation and high interest rates. The twin crisis (BOP and the financial sector) together with tight monetary policy led to a severe recession with real GDP shrinking by 8.4 percent in the third quarter of 1998 compared with the same quarter in the previous year.

Korea-Macro Fiscal Developments

Parameters
Real GDP gowth

1995 7.00

1996 4.65

1997 -6.85

1998 9.49

1999 8.49

Change in overall balance (in percent of GDP)

-0.07

-1.66

-2.46

1.41

3.60

Change in structural balance Change in structural revenue

-0.37 0.81

-1.78 -0.06

-0.01 0.96

0.24 0.41

2.84 3.09

Change in structural expenditure

Inflation NPL

1.17
4.92

1.73
4.44

0.97
7.51 7.40

0.17
0.81 8.30

0.25
2.26 8.90

Recovery Strategy- Focused on

improving the balance sheet of the financial and corporate sectors.
Two major commercial banks were nationalized; and the government initiated the exit process of non-viable financial institutions through mergers, debt-equity swaps, and liquidations. In 1998, five of 33 banks were closed, and three banks were merged. At the same time, the government supported the remaining financial institutions through full deposit guarantees, recapitalization, and purchase of bad loans. Furthermore, the centralized support packages enabled the government to control most of the financial institutions decisionmaking process. Eight major creditor banks, identified as leading banks, took the responsibility for negotiating workouts with the 64 major corporate groups

 In order to facilitate the restructuring process of the corporate sector, some legislative changes were made -Including the liberalization of hostile takeover by foreigners -Removing the limit to foreign ownership -Provision of tax incentives -Measures to improve labor market flexibility. Fiscal support to the economy mostly focused on the financial sector. And despite the collapse of the real sector in 1998, little fiscal stimulus directly supporting aggregate demand was provided. Most of the financial (and institutional) resources that the government could mobilize were spent on stabilizing the financial sector and the balance sheet of the corporate sector. These efforts were followed by fast recovery of the economy in 19992000 (real growth at 9 and 8, respectively).