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Fiscal Policy

Fiscal Policy

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Fiscal Policy

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  1. Fiscal Policy

  2. Can you run a deficit every year?

  3. Sustainable Deficit • If then Debt-to-GDP ratio stays stable. • If > then deficit is “unsustainable” A growing economy allows the government to borrow some money every year and still keep debt in line with overall GDP

  4. IMF Fiscal Indicators

  5. Crisis spreads to other countries IMF Fiscal Monitor Background Reading

  6. Primary Deficit • Simplified Government Budget Primary Outlays (Total Expenditure less Interest Paid) - Primary Receipts (Total Revenue less Interest Income) Primary Budget Deficit + Net Interest Payments on Existing Debt General Budget Deficit

  7. Sustainable Primary Deficit • If • then stays stable.

  8. Primary Balance % of GDP

  9. Consequences of Deficits • Austerity • Inflation • Default

  10. Austerity and the Output Gap • Economy in LT equilibrium • Government imposes austerity program – cuts spending, transfers, inceases taxes • AD Curve shifts inward. YP P SRAS 1 2 P* AD AD′ Y* Y Recessionary Gap

  11. Austerity has a negative effect on business cycles. • IMF

  12. Deficits and Inflation • Government generates revenues by printing new money (referred to as seignorage). • Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing and real returns to owning money. • Explain the link between deficits and inflation.

  13. Israel 1970-1990

  14. Israel 1970-1990

  15. Default and RestructuringArgentina 1999-2002 BBC Story IMF Study

  16. Stabilization policy • In an economy subject to shocks to aggregate demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism. • However, if this self-correction mechanism takes a long time to work, then government may use policy to speed adjustment. • Use expansionary policy to close a recessionary gap • Use contractionary policy to close an inflationary gap

  17. Demand Driven Recession w/ Counter-cyclical fiscal policy YP P • Economy in LT equilibrium • Demand shifts in • Government increases spending to shift the AD curve back 3 SRAS 1 2 P* AD AD′ Y* Y Recessionary Gap

  18. Demand Driven Expansion w/ Counter-cyclical fiscal policy YP P • Economy in LT equilibrium • Demand shifts out • Government cuts spending to shift the AD curve back SRAS 2 P* 1 AD′ 3 AD Y* Y Inflationary Gap

  19. Lags and Fiscal Policy • Administrative lags for fiscal policy may likely be large. • Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming. • If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.

  20. Automatic Stabilization • Governments in most economies issue debt to make up for shortfalls in revenues in relation to spending. Budget Deficit = Outlays – Revenues • Tax collection is cyclical so the budget deficit tends to be counter-cyclical. • Maintaining a balanced budget over the cycle means raising taxes in a recession an cutting taxes in a boom which makes the business cycle more extreme.

  21. Counter-cyclical deficits

  22. Learning Outcomes • Use growth rate of GDP, interest rates, and the debt to GDP ratio to identify the sustainable general and primary deficit level. • Use AS-AD model to identify the effects of fiscal policy on the output gap and the inflation rate.