Fiscal Policy and the Business Cycle Changes in the AS/AD curves cause actual real GNP to swing around natural real GNP. That is, the business cycles tends.

Fiscal Policy and the Business Cycle

• Changes in the AS/AD curves cause actual real GNP to swing around natural real GNP.

• That is, the business cycles tends to move from recession to boom and back again.

• According to Keynesian theory, these booms/recessions can persist for long periods of time.

• Keynesians advocate an active fiscal policy (changes in government expenditure and/or taxes) to try to stabilise the business cycle.

• This keeps actual GNP close to natural GNP over time.

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Growth rate ofpotential GDP

Actual growth rateInflation gap

Unemployment gap

Time

%change

Stabilisation policy

5 – 6%

Boom

Recession

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Assessing the Stance of Fiscal Policy

• A recession automatically worsens the budget deficit. Tax revenues fall and social welfare spending rises.

• Boom period, the deficit falls. • Define: Budget surplus = T – [G + SW]• Defining net taxes (NT) as:• NT = T – SW• NT is the proportion of government tax revenue and

spending that varies with fluctuations in nominal GNP.• Positive relationship between NT and GNP.• Current spending (G) is assumed to be constant.

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Continued

• Diagram shows how the budget balance varies as GNP changes. (Diagram 1)

• Recession: Budget deficit.• Boom: Budget surplus.• Note distinction between automatic and discretionary

changes in the budget balance. (Diagram 2)• Discretionary change occurs when the government

deliberately changes G, T or SW.• The result is a balanced budget at different levels of GNP.

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Government expenditure (G)

GNP1

AB

GNP2

C

Nominal GNP

NT

GNP

€ billions

Full-employment budget

G, NT

Budget surplus

Budget deficit

*

Natural GNP

Balanced budget

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Government expenditure (G)

GNP1

AB

GNP2

C

Nominal GNP

NT

GNP

€ billions

Discretionary changes in taxes and expenditure

G, NT

*

Natural GNP

NT

NT

1

2

3

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Natural GNP Budget

• At what level of GNP should the government attempt to balance the budget?

• It is argued that the relevant budget balance is the natural GNP budget surplus.

• That is, the government should choose a combination of taxes and expenditure that balances the budget if the economy were at natural real GNP.

• This entails tolerating a deficit in times of recession and a surplus when the economy is over-heating.

• The problem is that it is not easy to calculate the natural GNP budget.

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Problems Encountered in Stabilising the Business Cycle

• The government is counter-acting shifts in either the AS or AD curves using only fiscal policy.

• However, this is not an effective response to dealing with an adverse supply-side shock.

• It solves the real GNP/unemployment problem but it makes inflation worse.

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Policy Lags

• Recognition lag: a delay in realising the economy has gone into boom or recession. Data is out-of-date.

• Decision lag: a delay in deciding how to spend, cut expenditure or change tax rates.

• Implementation lag: for instance, tenders for projects delay expenditure.

• Outside lags: the time policy takes to impact on the economy.

• Government policy could be out-dated by the time it is implemented and could end up destabilising, rather than stabilising, the business cycle.

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Natural growth rate

Actual growth rate

Economy hit by “shock” goes into recession

Expansionary fiscal policyimplemented at this point

Time

%change

How a stabilisation policy de-stabilises the business cycle

5 – 6%

Boom

Business cycleautomatically rights itself

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Continued• Changes in taxes can give unpredictable

results. Refer to the Laffer curve.• Examine relationship between tax rate and tax

revenue. • Optimal tax rate: T*

• Below optimal: normal positive relationship.• Above optimal: an increase in tax rate may lead to

a decrease in tax revenue. High taxes affect the “incentive to work” and drive industry into the black economy, as we saw in Ireland in the mid-1980’s.

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Averagetax rate

100%

0 %

T

T

T

1

*

2

R 1 R 2

Revenuemaximizingtax rate

Tax revenue £m

A

B

Laffer Curve

Z

Leddin and Walsh Macroeconomy of the Eurozone, 2003

Dynamically Unstable Debt

• Problem with Fiscal policy in recession

• Debt grows exponentially as economy declines and we borrow merely to pay interest on the stock of debt– Problem in 1980s– Could be problem again

• Key variable is d=D/Y– Debt-GDP ratio– “debt burden”

• d evolves according to the following equation

• Where – r is the interest rate

– g is the growth rate

– p is the “primary balance”: G-T excl. interest

• Difference equation with impulse and potentially explosive growth

• Intuitive– Maths online

ttttt grdd )(

Primary Balance % GDP

-15

-10

-5

0

5

10

1970

1971

1972

1973

1974

1975

1976

1977

1978

1979

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Year

% G

DP

Fiscal rules

Just as monetary policy has been taken

over by independent central banks, out of

the reach of politicians, should fiscal

policy be removed from the political

arena by subscribing to a fiscal rule?

Alternative fiscal rules

• The EU Stability and Growth Pact

• The Golden Rule

• Stabilize the debt/GDP ratio

• Sustainable investment rule

National fiscal policy and the Stability Pact

The Stability and Growth Pact (SGP) was framed at the Dublin summit, December 1996, and ratified at the Amsterdam Summit, June 1997

Designed to prevent backsliding by countries that had met the Maastricht criteria

The SGP• Formalises the “Excessive Budget

Deficits” procedure• Fiscal deficits should average at most 1%

of GDP over the business cycle• Deficits in excess of 3% of GDP will

attract penalties unless they were due to “exceptional” and/or “temporary” Could imply pro-cyclical transfers from countries to the centre.– Fiscal federalism in reverse

SGP

• Countries have to prepare a Stability Programme when presenting their national budgets

• This Programme contains projections of General Government Balance for four years showing that national fiscal policy respects the SGP

SGP: Rise, Fall and Rise Again

• Ireland was reprimanded in 2001 because the Council felt that Budget 2001 was too expansionary– But the stagnation of the Eurozone economy

during 2002 has lessened the appetite for enforcing the SGP

– Portugal, Germany, Italy, and France at or above the 3% ceiling

• The deadline for reaching a balanced budget postponed from 2004

to 2006

• Then France ignored SGP in formulating its 2003 Budget

– Proposal to Scrap it

– Prodi: “All rigid rules are stupid. The SGP is a rigid rule”

• All changed now because of Greece and Ireland

• Modify it:

– “cyclically adjusted” budget balance, taking account of the automatic

stabilisers

The Golden Rule• Alternative to SGP

– Was followed by UK

• Over the business cycle the government should borrow

only to invest and not to fund current spending

– No current deficits, but

– Future generations should contribute to the costs of

infrastructure from which they benefit

• We adhered roughly to this rule in Ireland until the late

1970s

• Is being suggested as part of new European rule

Problems with The Golden Rule

• The threshold between current and capital spending

is not hard-and-fast

– Education? Health? Etc

• Is government capital formation efficient?

• Until the crisis government capital formation

accounted for borrowing equal to about 4.5% of

GDP

• What happens if break it? Precedent of SGP

Sustainable Debt Rule

• The debt/GDP ratio will be stabilized at a

“prudent” level.

– Maastricht criterion was 60%

– UK Chancellor (Gordon Brown) defined it as 40%

• There is no well-defined “optimal” level

• And even if there were, it would change over

time

– See the maths of debt dynamics

Conclusion On Rules

• Present Crisis: There is need for a rule

– but a rigid one is undesirable

– Probably unenforceable

• Projections of GDP, tax revenue, and spending are

uncertain

• Rule should force the present generation to pay for

the level of spending on (current) public services it

desires