GE04: Fundamental of Business Economics

Lecture 12: Fiscal Policy

Presented by
Dr. M. Anwar Ullah, FCMA

The Institute of Cost and Management Accountants of Bangladesh

ICMA Bhaban, Nilkhet, Dhaka – 1205
war2

05/12/24 1
1. What is fiscal policy?
2. What is the difference between discretionary and
nondiscretionary fiscal policy?
3. What is the cause-effect chain for expansionary and
contractionary fiscal policy?
4. What are the automatic stabilizers?
stabilizers
5. What is the “crowding-out” effect?
6. What are the “lags” involved in fiscal policy?
7. What is “Supply-side” economists?
8. How fiscal policy can “stabilize” the economy?
9. What about government borrowing and public debt?
 Basic objectives of the Fiscal Policy

 Adhering to fiscal discipline

 Generating high primary surplus
 Reducing public debt
 Contributing to sustainable growth
 Supporting struggle against inflation
 Establishing a taxation system,
 Supporting growth and employment policies and
reducing unregistered economy
 Completing reform activities in public financial
management
 Balanced Budget [Tk. 200 billion “G” = Tk. 200 billion “T”]

200 billion 200 billion

Recession
Deficit so
Incr G to 220
higher I.R.
or
hey have to
Decr T to 118 borrow
So expansionary fiscal policy
leads to higher interest rates.
G T Deficit

Inflation
Decr G to 118 Surplus so
or
Budget Lower I.R.
Incr T to 200 Wow! A
surplus
So, contractionary fiscal policy
leads to lower interest rates.
 Expansionary Fiscal Policy shifts the AD curve rightward, increases Y*
and P*.
Contractionary Fiscal Policy shifts the AD curve leftward, decreases Y*
and P*.
Note -- like monetary policy, fiscal policy is justified only from a short-run
perspective.
FISCAL POLICY IN THE OPEN ECONOMY
Shocks Originating from Abroad
Net Export Effect (Xn)
• Nothing arouses as much
controversy as the role of
government in the economy.

• Government can affect the macro economy through two policy channels:
Fiscal Policy and Monetary Policy.
– Fiscal policy is the manipulation of government spending and
taxation.
– Monetary policy refers to the behavior of the Bangladesh Bank
regarding the nation’s money supply.
Circular Flow of Income

Source: @2002 Prentice Hall Business Publishing)

 Structural Budget and Cyclical Budget
• Governments use budget to control and record their fiscal affairs.
Government budget shows, for a given year, the planned expenditures of
government programs and the expected revenues from tax systems.

• A budget surplus occurs when all taxes and other revenues exceed
government expenditures.

• A budget deficit occurs when expenditures exceed revenues.

• When expenditures and revenues are equal during a given period, the
government has a balanced budget.

• The structural budget calculates what government revenues, expenditures

and deficits would be if the economy were operating at potential output.

• The cyclical budget calculates the effect of the business cycle on the budget
– measuring the changes in revenues, expenditures, and deficits that arise
because the economy is not operating at potential output.
 Strategy of Fiscal Policy

• Expansionary fiscal policy: increasing the budget deficit (G↑ or

T↓) usually in a recession. This policy will seek to induce more
purchasing of goods and services by increasing (G - T) -- i.e. G
or T.

• Contractionary fiscal policy: decreasing the budget deficit (G↓ or

T ↑) usually in an economic boom. This policy will seek to induce
less purchasing of goods and services by decreasing (G - T) -- i.e.
G or T.
Types of fiscal policy

 Discretionary fiscal policy: This is fiscal policy that comes about

from planned changes in G and T that the government brings in, in
response to the economic situation.

 Non-discretionary fiscal policy: This is fiscal policy that comes

about from the design of spending and taxes. There is no government
official actively determining these changes.
 AD1 SRAS
AD2
LRAS
Price Level

Recessions
Decrease in AD
PL1

270 290 Real GDP

YR YF (in Billion Tk.)
 Expansionary Fiscal Policy
[Increase “G” or “decrease “T” w. ME of 4]
Full Tk. 20 Billion
Increase in AD
AD1
AD2 LRAS SRAS

Tk. 5 Billion in
Price Level

additional
G spending
PL1

270 290 Real GDP

YR YF (in Billion Tk.)
 Even if I have to dig a hole
and cover it back up, I do
have a job.

Discretionary Fiscal Policy

[“G
[“ ” & “T
“ ”] can be used if John Maynard Keynes
“Father of Fiscal Policy”
further smoothing is required.
Nondiscretionary Fiscal Policy can take
33% to 50% of the curves out of the business cycle.
[Automatic stabilizers, like welfare and unemploy. insur.]
Peak Co
Peak nt
Co ra

n
nt ct

io
ra io
Peak

ns
ct Connt
Peak i
Cont on
pa
n racti
racti Ex nsio on
on pa
Ex

Trough
Trough
Discretionary
Fiscal Policy
Unempl. check
Deliberate use of government
spending and/or taxing.
“G” and “T”
Discretion of Parliament
Nondiscretionary
Fiscal Policy
Automatic Stabilizers
1.Welfare & food stamps
2. Unemploy. insurance
3. Social security
4. Corporate Dividends
5. Progressive Tax System
 Non-discretionary fiscal policy
• Certain parts of our spending and taxes automatically
increase demand in a recession (when AD < potential
GDP) and decrease demand in a boom (when AD >
potential GDP).

– Welfare spending and unemployment benefits are part of G

and increase in a recession and decrease in a boom.
– Income and company taxes are part of T and depend on GDP,
they increase during a boom and decrease during a recession.

• These act as “automatic stabilizers” on the economy,

reducing the variability of the economy.
Discretionary fiscal policy
• Discretionary fiscal policy is the manipulation of G and T by
government officials typically to reduce the severity of shocks to
the economy.

• It sounds like a good idea, but how does it work in reality?

• There are many problems and limitations to the use of fiscal policy
to reduce recessions and booms.

Problems with discretion

• Scenario: Imagine a train driver that has only one control- an
accelerator/brake that he or she can push or pull on to control the
train. This is exactly the same situation as the government faces
with fiscal policy.
• Now what limitations can the train driver face?
 Problems with discretion
Limitations:
– Correctness of data: Is the train driver seeing the tracks
correctly? Or Does the government get the right data about
where the economy is?
– Timing of data: Is the train driver seeing the tracks with
enough time to react? Or Does the government get the
statistics quickly enough to do anything?
– Decision lags: Can the train driver make a decision about
the correct action before the train reaches the problem
spot? Or does the government have time to design the
correct fiscal policy?
 Problems with discretion
– Administration lags: If the driver pulls on the control, how
long will it take for the brakes to start to work? Or New
spending and taxes have to be passed through parliament,
which takes time, even after a decision is made.
– Operational lags: If the brakes start to work, how long
before the train slows down? Or New government spending
and taxes take time to affect the economy.

So, even the best-designed fiscal policies can go wrong if

they are in response to the wrong data or if they take
too long to affect the economy.
 Political considerations
There are further concerns we might have about the
operation of fiscal policy.
– Politicians have to remain popular. No one likes taxes,
and everyone likes new spending on themselves. Will a
politician make an unpopular decision that may result in
them losing the election if it is the best decision for the
economy.
– Electoral cycles: Governments have to be re-elected every
5 years. So a politician would love to engineer a boom right
before his or her election.
 Cyclically-adjusted budget deficits
• The automatic stabilizers raise the budget deficit in a
recession and lower the budget deficit in a boom.

• This fact means that we can not just look at the budget
deficit to determine whether the government is
“overspending”, we also have to take into account where
we are in the business cycle.

• Adjusting the budget deficit for the point we are in the

business cycle is called “cyclically adjusting”. We
would expect even a “sensible” government to be in a
deficit in a recession.
 Fiscal Policy Instruments
 Automatic stabilizers act to reduce business-cycle
fluctuations.
 Progressive taxes – the average tax rate rises as
income rises.
 Unemployment insurance, welfare and other transfers
are designed to supplement incomes and relieve economic
hardship.
 Subsidies on production in the farm sector.

 Discretionary fiscal policy

 Public works
 Public employment projects
 Varying tax rates
 Automatic stabilizers
Automatic Stabilization -- due to the income tax system, tax revenues
change in directions that help to stabilize the economy, without any
change in the tax structure (i.e. fiscal policy)

Suppose the economy is in recession:

Tax
Real GDP collections

Transfer
AS payments
AD1
AD2

PL
YR Y*
G>T
“Recession” The deficit grows
 Automatic stabilizers

If the economy has an inflationary gap:

gap
Tax
collections
Real GDP Transfer
AD2 AS payments
AD1
PL
G<T
Y* YI
“Inflationary Gap” The surplus grows
 Peak Peak

Raise
Raise “T” AS
“T” AD2
AD3 AD1
PL2 Deficit Raise
Trough
Spending Taxes
Deficit Spending PL1
“Balance the economy over the PL3
course of the Business Cycle”
YR YF YI

Bus. Cycle

“Even if the jobs are digging

Recess – Lower T
holes and filling them up.” Inflat – Raise T
Deficits Surpluses
 Financing Deficit
• Government can borrow funds from the other sectors of the
economy. This involves the selling of government securities
such as treasury bonds. Government competes with the
private sector for domestic savings, creating what is referred
to as a “crowding out effect”.
• Government supports export.
• Government sells securities to the central bank. This form of
borrowing from the CB basically means that the government
prints money to finance the deficit.
• Government borrows funds from international financial
markets. If government borrows funds from overseas it can
reduce the crowding out effect.
 Expansionary fiscal policy creates an increased need for more
borrowing by the government.
 This financing increases the demand for financial capital. As a
result, long-term interest rates (r*) rise and Investment (I*) decreases.
 Crowding Out Effect -- makes fiscal policy less effective than would
be otherwise.

 Decrease in investment to some extent offsets rise in (G - T).

 Smaller shift in AD curve than would be without the crowding out

effect.
 Crowding Out Effect  loss of Investment (I).
 Decrease in Investment retards the buildup of the capital stock and
possible implementation of new technology (i.e. Labor Productivity
growth).
 Smaller shifts in LAS curve, smaller increases in YF
 Crowding out
• The crowding out hypothesis: government spending
reduces private investment. When government spends
people's money on public works projects these funds
simply crowd out private investment.
• Another problem with fiscal policy is that an increase
in G may increase output but at the expense of other
components of aggregate expenditure.
Y = C + I + G + NX
• Since the economy returns to potential GDP over the
long-run, an increase in G must come at the expense
of either C, I or NX or all 3.
• If an increase in G reduces investment spending over
the long-run, this could lead to lower future growth in
the economy.
 Crowding out
How can this happen?
– An increase in G shifts the AD curve to the right.
– This results in higher Y and higher P.
– The increased government borrowing in the market for
savings raises the interest rate.
– Higher interest rates lead to lower investment spending so
I drops, shifting AD left.
– Higher interest rates leads to an appreciation of the A$ (as
foreign investors put their money in Australia), so NX
drops, shifting AD left.
How to Avoid the Crowding Out Effect?
Bottom line -- get the supply of financial capital to shift rightward
at the same time as when expansionary fiscal policy occurs.
-- expansionary monetary policy
-- increased private saving
-- increase in foreign capital
inflows
1. Data (recognition) lag
2. “Wait-and-see” lag – short run
3. Legislative lag (political)
4. Effect lag [takes months]