FISCAL POLICY – VF 461

WARRANTER : VRATISLAV IZÁK

YEAR 2002

FACULTY OF FINANCE AND ACCOUNTING

UNIVERSITY OF ECONOMICS, PRAGUE

SYLLABUS HAS BEEN ELABORATED IN THE FRAMEWORK OF

A DEVELOPMENT PROGRAM OF THE MŠMT

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AIM :

The aim of the course is to make the students acquainted with short, medium and
long run aspects of fiscal policy, with its microeconomic background and
macroeconomic consequences. Both conventional (keynesian) and classical approaches
are carefully evaluated

CREDITS : 2 (2/0)

13 lectures (28 hours)

COMPLETION : written examination

Titles of the themes :

1) Fiscal policy in the IS-LM model

2) Fiscal policy in the AS-AD model
3) The impact of expectations on the fiscal policy
4) Fiscal policy in an open economy
5) Saving, budget deficits and capital accumulation
6) Fiscal deficits, financial crisis and high inflation
7) The case of Ricardian equivalence
8) Supply side policies
9) Fiscal policy and political decision making
10) The implications of the government budget constraint
11) Structural and cyclically adjusted deficits
12) Fiscal policy in a monetary union
13) Fiscal policy in an economy in transition

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Literature :

Basic:
1) Barro R.: The Ricardian Approach to Budget Deficits, Journal of Economic
Perspectives, 2/1989, p.37-54
2) Barro R., Grilli V.: European Macroeconomics, Macmillan, London, 1994, ISBN 0-
333-57764-7
3) Blanchard O.: Macroeconomics, Prentice Hall, New Jersey, 2000, ISBN 0-13-017395-
9
4) European Economy-Public Finances in EMU, 3/2001, 80p.
5) Giorno C., Richardson P., Roseveare D., van den Noord P.: Estimating potential
output, output gaps and structural budget balances, OECD, WP 152/1995, 53p.
6) Gordon R.: Macroeconomics, Addison-Wesley Longman, New York, 1997, ISBN 0-
321-01438-3
7) How to Measure the Fiscal Deficit: Analytical and Methodological Issues, edited by
M. Blejer and A. Cheasty, IMF, Washington, 1993

Supplementary:
1) Alesina A., Perotti R.,: Fiscal Adjustment in OECD countries: Composition and
Macroeconomic Effects, IMF, WP 70/1996, 46p.
2) Caselli F., Giovannini A., Lane T.,: Fiscal Discipline and the Cost of Public Debt
service: Some Estimates for OECD countries, IMF WP 55/1998, 22p.
3) Elmendorf D., Mankiw G.: Government Debt (Ch. 23) in Handbook of
Macroeconomics, Vol.I, Elsevier, 1999
4) Izak V.: Fiscal Policy: The Necessary but Not Sufficient, Ch.3 in Lessons in Economic
Policy for Eastern Europe from Latin America, edited by G.Mac Mahon, Macmillan,
London, St. Martin´s Press, New York, 1996, ISBN 0-312-12647-6
5) Knot k.: Fiscal Policy and Interest Rates in the European Union, E. Elgar, Cheltenham,
UK, 1996
6) Noord van den P.: The Size and Role of Automatic Fiscal Stabilizers in the 1990´s,
OECD, WP 230/2000, 29p.
7) Perkins J.: Budget Deficits and Macroeconomic Policy, 1997
8) Tanzi V.: The Budget Deficit in Transition, IMF Staff Papers, 3/1993,p.697-707

For the student´s convenience lecture notes (approximately 100 pages)

summarizing the main content of the themes are at the disposal

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FISCAL POLICY IN THE IS-LM MODEL
THEME 1

a) After working through theme 1 you should understand the interaction among demand,
aggregate production and income in the simple model of income determination in the
short run. The role of fiscal policy in this model is a clear one. Increases in
government spending and decreases in taxes both increase output. Looking at goods
and financial markets together we create a framework to think about how output and
the interest rate are determined in the short run. To most economists the IS-LM model
still represents an essential building block-one that, despite its simplicity, captures
much of what happens in the economy in the short run.

b) Fiscal policy in a model of income determination

. A fiscal expansion and a fiscal contraction
The dynamic effects of a change in fiscal policy
Policy mix (monetary and fiscal policy)

c) Fiscal policy in a model of income determination, where consumption, investment

and government expenditure are all exogenous variables. In equilibrium aggregate
demand equals income and the multiplier is deduced. Fiscal policy in this model
analyses what happens to output if autonomous spending (government expenditure)
changes. A fiscal expansion occurs when government purchases increase or when
taxes are cut. A fiscal contraction occurs when government purchases are cut or when
taxes are increased. Both expansion and contraction cause a change in income and
the interest rate. Policy mix (a combination of monetary and fiscal policies) is
sometimes used for a common goal.

d) In equilibrium, when aggregate demand equals income we solve one equation with
one unknown. The solution for the equilibrium level of output yields the important
concept of the multiplier. It means, e.g., that every one crown change in government
expenditure causes a „multiplied“ change in equilibrium output. To summarize, e.g. a
fiscal contraction will cause a reduction in income (due to a reduction in demand), a
lower interest rate (due to a reduction in demand for money), a reduction in
consumption and saving via the reduction in disposable income and an ambiguous
effect on investment (the lower interest rate causes an increase in the investment and
the lower income causes a reduction in investment). The dynamic effects of an
increase in government expenditure are: their increase causes an increase in demand;
firms respond by slowly increasing income; as soon as income begins to increase,
money demand rises and the interest rate rises to maintain financial markets
equilibrium; therefore as income increases, the economy moves along the LM curve.
Income continues to increase (and the interest rate rises) until the new equilibrium is
reached. Monetary policy can accommodate fiscal expansion. In this case the central
bank must increase the money supply as money demand increases to keep the
interest rate at the initial level. This will shift the LM curve down and the new
equilibrium will be reached at higher output level.
Summarizing, in the IS-LM model fiscal policy is the most effective when
investment demand is independent of the rate of interest (the IS curve is vertical and

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 there is no crowding out) and when money demand is completely elastic with respect
to the interest rate (the liquidity trap, the LM curve is horizontal).
e) model IS-LM, IS equation, LM equation, fiscal expansion, fiscal contraction,
monetary-fiscal policy mix

f) homework:
Suppose the economy is represented by the following equations:

Md = 6 Y – 120 i Ms = 5400

C = 180 + 0,7 (Y – T) T = 400 G = 400 I = 100 – 18 i + 0,1 Y

a. Write out the equation for equilibrium in the goods market, Solve for the
equilibrium level of output.
b. Write out the equation for equilibrium in the financial market. Solve for the
equilibrium level of the interest rate.
c. Substitute the expression for i (in part b) into your equation for y in part a.
Calculate the overall equlibrium level of output.
d. Calculate the equilibrium i by substituting the value of Y (from c) into your
equation in(b).
e. At this equilibrium what is the level of C and I ?
f. Calculate the new equilibrium value of Y, i, C and I when G increases by 10
(from 400 to 410). What happened to investment as a result of this fiscal
expansion ?
g. Using the original values of the variables, calculate the new equilibrium
values of Y, i, c and I when M increases by 200 (from 5400 to 5600). What
happened to investment as a result of this monetary expansion ?

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 FISCAL POLICY IN THE AS -AD MODEL
THEME 2

a) To think about the determination of output in both the short run and in the medium run
requires taking into account equilibrium in all markets (goods, financial and labour).
We do so by deriving two important relations: the aggregate supply relation which
captures the implications of equilibrium in the labour market and the aggregate
demand relation which captures the implications of equilibrium in both the goods and
financial markets. Then we are able to look at the effects of fiscal policy in the short
and medium run. We will see that in the medium run changes in fiscal policy have no
effect on output and are simply reflected in a different composition of spending.

b) Wage determination in the labour market

Price determination in the labour market
The move from unemployment to output
Putting all markets together – the AS-AD model
Fiscal policy in both the short and medium run

c) Firms respond to an increase in aggregate demand (due to e.g. expansionary fiscal

policy) in the medium run. At the center of this adjustment process is the labour
market. So we must combine our earlier treatment of goods and financial markets with
the knowledge of the labour market. The nominal wage depends on 3 factors (the
expected price level, the unemployment rate and a catchall variable that stands for all
other variables that affect the outcome of wage setting. In price setting we assume the
markup over costs. In the medium run, output tends to return to the natural level and
the factors that determine unemployment and output are the factors influencing the
movement of wages and prices. Therefore, in the medium run, fiscal policy does not
affect output forever, but only temporary, and output returns to its natural level.

d) When firms respond to an increase in aggregate demand due to expansionary fiscal

policy by stepping up production then higher production requires an increase in
employment; higher employment leads to lower unemployment; lower unemployment
puts pressure on wages; higher wages increase production costs, forcing firms in turn
to increase prices; higher prices lead workers to ask for higher wages and so on. This
sequence of events can not be ignored, therefore the labour market must be analysed.
Wage determination implies a negative relation between the real wage and the
unemployment rate. As many markets are not competitive, firms charge a price higher
than their marginal cost-they use a markup of price over cost. To move from
unemployment to output we use a simple production function. We know from other
courses that associated with the natural level of employment is a natural level of
output when the expected price level is equal to the actual price level. Thinking about
the determination of output in both the short run and in the medium run requires taking
into account equlibrium in all three markets (goods, financial and labour). The
aggregate supply relation captures the effects of output on the price level, whereas the
aggregate demand relation captures the effect of the price level on output. But the
equilibrium output (the intersection of AS and AD ) can be above or below its natural
level. Then the dynamics of adjustment must follow. The dynamic effects of changes
in fiscal policy-e.g. a decrease in the budget deficit do not affect output forever.
Eventually, output returns to its natural level but the price level and the interest rate
are now lower than before the shift in fiscal policy. By assumption, government

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 spending is lower than before, consumption is the same, therefore investment must be
higher than before deficit reduction-higher by an amount exactly equal to the decrease
in the budget deficit. Put another way, in the medium run, a reduction in the budget
deficit unambiguously leads to a decrease in the interest rate and an increase in
investment.

e) Wage setting relation, price setting relation, natural rate of output, deficit reduction,
adjustment process

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THE IMPACT OF EXPECTATIONS ON THE FISCAL POLICY
THEME 3

a) In sharp contrast to the simple models we analysed in the first two themes, we will
show, in this third theme, that a fiscal contraction may, under the right circumstances,
lead to an increase in output, even in the short run. How expectations respond to
policy are at the center of the story.

b) Expectations and the IS relation

Expectations and the LM relation
Deficit reduction, expectations and output
The Irish example

c) We distinguish several kinds af expectations-animal spirit, adaptive expectations and

rational expectations. Our equation for aggregate demand must be reformulated by
introducing expected values of income, taxes and the real interest rate. The present and
the future are reduced to only two periods: a current period and a future period.
Introducing the expected values into the IS relation causes a change in the steepness of
this curve. The LM relation is, even after the revision, unchanged and the expected
values have no impact on the LM curve known from lecture 1. If firms , households
and financial market participants have rational expectations, then, in response to the
announcement of a deficit reduction, the output may increase even in the short run.
This result is in a contrast with the result in a very simple model in theme 1.

d) In this theme the introduction of expectations into the IS relation shows that: increases
in either current or expected future income increase private spending, increases in
either current or expected future taxes decrease private spending and increases in
either the current or expected future interest rate decrease private spending. The new
IS curve is still downward sloping, but is much steeper than the IS curve we drew in
the first lecture. Put another way, a large decrease in the current interest rate is likely
to have only a small effect on equilibrium output. The effect of the decrease in the real
interest rate on output depends on the strength of two effects: the effect of the real
interest rate on spending given income and the size of the multiplier. Changes in
current taxes or in government spending shift the IS curve. Changes in expected future
variables also shift the IS curve. The LM curve has not been modified. How much
money one wants to hold today depends on his current level of transactions, not on the
level of transactions one expects next year or the year after; there will be time to adjust
his money balances to his transaction level if it changes in the future. To summarize:
Expectations about the future play a major role in spending decisions. This implies
that expectations enter the IS relation.
In the past 10 years several economists have questioned the conclusion of the first
lecture that, in the short run, unless it is offset by a monetary expansion, a reduction of
budget deficit leads to a reduction in spending and so to a contraction in output. Their
basic argument is simple: If people take into account the future beneficial effects of
deficit reduction, their expectations about the future may improve enough to lead to an
increase rather than a decrease in current spending and so an increase in current output.
To summarize: A program of deficit reduction may increase output even in the short
run. Whether it does depends on many factors, in particular : On the credibility of the
program, on the timing of the program, on the composition of the program and on the
state of government finances in the first place. This gives a sense of both the

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 importance of expectations in determining the outcome and the difficulty of
predicting the effects of fiscal policy in such a context.

e) modified IS curve, adaptive expectations, rational expectations, deficit reduction

f) For a more detailed discussion of what has been learned by looking at programs of
deficit reduction : J. McDermott, R. Wescott : An empirical analysis of fiscal
adjustments, IMF working paper, June 1996

g) Example for home thinking over:

Can a budget deficit reduction lead to an output expansion ? The example of Ireland in
the 1980s.

Ireland underwent two major deficit reduction programs in the 1980s.

1) The first program began in 1982. In 1981 the budget deficit had reached a very
high level – 13% of GDP. Government debt, the result of the accummulation of
current and past deficits, stood at 77% of GDP, also a very high level. The
government clearly had to regain control of its finances. Over the next three
years it embarked on a program of deficit reduction based mostly on tax
increases. This was an ambitious program had output continued to grow at its
normal rate, the program would have reduced the deficit by 5% of GDP.
The results were dismal. As shown in line 2 of Table 1 output growth was low
in 1982 and negative in 1983. Low growth was associated with a major increase
unemployment, from 9,5% in 1981 to 15% in 1984 (line 3). Because of low
output growth, tax revenues were lower than anticipated. The actual deficit
reduction, shown in line 1, was only 3,5% of GDP. And the result of continuing
high deficits and low GDP growth was a further increase in the ratio of debt to
GDP to 97% in 1984.
2) A second attempt was made starting in February 1987. The economy was still
In very bad shape. The 1986 deficit was 10,7% of GDP; debt stood at 116% of
GDP, a record high in Europe at the time. This new program of deficit reduction
was different from the first. The focus was more on a reduction of the role of
government and a decrease in government spending, rather than on an increase
in taxes. The tax increases in the program were achieved through a tax reform
widening the tax base and without an increase in the marginal tax rate on
income. The program was again very ambitious. Had output grown at its normal
rate, the reduction in the deficit would have been 6,4% of GDP.
The results could not have been more different from those of the first program.
The years 1987 to 1989 marked a period of strong growth, with average GDP
growth exceeding 5%. The unemployment rate was reduced by 2%. Because of
strong output growth tax revenues were stronger than anticipated and the deficit
was reduced by nearly 9% of GDP.

Table 1
Fiscal and other macroeconomic indicators, Ireland, 1981-1984 and 1986-1989
1981 1982 1983 1984 1986 1987 1988 1989
1. Budget deficit (% of GDP) -13,0 -13,4 -11,4 -9,5 -10,7 -8,6 -4,5 -1,8
2. Output growth rate (%) 3,3 2,3 -0,2 4,4 -0,4 4,7 5,2 5,8
3.Unemployment rate (%) 9,5 11,0 13,5 15,0 17,1 16,9 16,3 15,1

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 FISCAL POLICY IN AN OPEN ECONOMY
THEME 4

a) Until now we have dealt with a closed economy which is an unrealistic assumption.
We must broaden our analysis by taking into account the openness of the economy. In
an open economy fiscal policy affects both output and the trade balance and there is
the relation between budget deficits and trade deficits. Fpolicy and exchange rate
adjustments can be used to affect both the level and the composition of output.

b) The IS relation in the open economy

Increases in domestic demand (government spending)
Multipliers in a small open economy
Combining exchange rate and fiscal policies

c) Openness has three distinct dimensions. Openness in goods markets means that the
consumers and firms can choose between domestic and foreign goods. Openness in
financial markets means the opportinity for financial investors to choose between
domestic and foreign financial assets. Openness in factor markets means the
opportunity for firms to choose where to locate production and for workers to choose
where to work and whether or not to migrate. In the short run and the medium run-the
focus of this lecture-openness in factor markets plays much less of a role than
openness in either goods or financial markets. The demand for domestic goods is an
increasing function of income. The trade balance is a decreasing function of output. If
the government increases its spending there is a well known multiplier effect but also
an effect on the trade balance. The multiplier is smaller than in the closed economy.
The effect of an increase in government spending is likely to be an increase in the
trade deficit. Thus, under certain conditions, a budget deficit can be reflected in a trade
deficit.

d) In an open economy one must distinguish between the domestic demand for goods and
the demand for domestic goods. Some of domestic demand falls on foreign goods and
some of the demand for domestic goods comes from foreigners. As income increases,
the domestic demand for domestic goods increases less than total domestic demand
(net exports are a decreasing function of output).
The question is how changes in demand affect output in an open economy. Let us
start again with an increase in government spending in a recession. The first impact of
this increase is the famous multiplier effect. But there is now an effect on the trade
balance. Not only does government spending now generate a trade deficit, but its
effect on output is smaller than in the closed economy. This means that the multiplier
is smaller in the open economy. The more open the economy, the smaller the effect on
output and the larger the adverse effect on the trade balance.
The trade balance can be improved following a depreciation when exports increase
enough and imports decrease enough to compensate for the increase in the price of
imports. (the Marshall-Lerner condition). If the government wants to reduce the trade
deficit without changing the level of output what is necessary is the combination of
exchange rate and fiscal policies. A depreciation alone will reduce the trade deficit, but
it will also increase output. A fiscal contraction alone will reduce the trade deficit, but
it will decrease output. The government must therefore use the right combination of
depreciation and fiscal contraction. A general lesson is: If the government wants to
achieve two targets (output and trade balance) it must have two instruments (fiscal

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 policy and the exchange rate). What is badly needed is an increase in foreign demand. It
leads, as a result of increased exports, to an increase in domestic output and an
improvement in the trade balance.

e) demand for domestic goods, IS curve in an open economy, multiplier in an open

economy, combination of exchange rate and fiscal policy

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SAVING, BUDGET DEFICITS AND CAPITAL ACCUMULATION
THEME 5

a) Both private and public saving affect the level of capital accumulation and the level of
output in the long run. Even, as is known from the theory of economic growth, the
saving rate does not permanently affect the growth rate, it does affect the level of
output and the standard of living.
b) Implications of alternative saving rates
Social security and capital accumulation
The dynamic effects of an increase in the saving rate

c) In this theme we analyse some impacts of fiscal policy in the long run. To understand
the determination of output in the long run we must keep in mind two relations
between output and capital: The amount of capital determines the amount of output
being produced. The amount of output determines the amount of saving and
investment and thus the amount of capital being accumulated. A country with a higher
saving rate achieves a higher level of output in steady state. The level of capital
associated with the value of the saving rate that yields the highest level of
consumption in steady state is known as the golden-rule level of capital. The empirical
evidence indicates that most OECD countries are far below their golden rule level of
capital. If they were to increase the saving rate, it would lead to higher consumption in
the future.
The intergenerational issues mean that governments face a trade-off: An increase in
the saving rate implies lower consumption initially, higher consumption later. The
current debate on social security reform reflects this mentioned trade-off.

d) We should be concerned about the saving rate which is composed from private and
public saving rate because it affects the level of output.The interactions between
output and capital have been studied in the theory of economic growth. We derive two
relations. From the production side capital determines output. From the saving side
output, in turn, determines capital accumulation. When we put them together we see
what they imply for the behaviour of output and capital over time.
The effects of the saving rate on the growth rate of output per worker can be
summarized in a three-part answer: The saving rate has no effect on the long run
growth rate of output per worker, which is equal to zero. Nonetheless, the saving rate
determines the level of output per worker in the long run. An increase in the saving
rate will lead to higher growth of output per worker for some time, but not forever.
Increases in capital beyond the golden rule level reduce steady state consumption.
If an economy already has so much capital that it is operating beyond the golden rule,
then increasing saving further will decrease consumption not only now, but also later.
Is this a relevant worry ? In OECD countries the saving rate is insufficient so the
increase in saving rate is desirable. The problem is the low public saving due to budget
deficits.
Mandatory expenses are the main culprit of this situation. The goal of social
security is to make sure retirees will have enough incxome to live on. It has become
the largest transfer program in many advanced countries. One can think of two ways
to set up and run a social security system: One is to tax workers and distribute the tax
contributions as benefits to retirees. Such a system is called a pay-as-you-go system.
The other is to tax workers, invest the contributions in financial assets and pay back
the principal plus the interest to workers when they retire. Such a system is called

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 fully funded.: at any time, the system has funds equal to the accumulated contributions
of workers and from which it will be able to pay out benefits when those workers retire.
From the point of view of the economy , the two systems are different. In a pay-as-you-
go system the contributions are redistributed, not invested. In a fully funded system
they are invested, leading to a higher capital stock. It seems that a move to a fully
funded system is desirable but it must be very slow, so that the burden of adjustment
does not fall too much on one generation relative to others.

e) saving rate, golden- rule level of capital, pay-as-you-go social security system, fully
funded social security systém

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FISCAL DEFICITS, FINANCIAL CRISIS AND HIGH INFLATION
THEME 6

a) The relation between fiscal policy, money growth and inflation has a long tradition in
the economic science. Inflation ultimately, in the long run, comes from money growth.
The empirical evidence confirms that in each country high inflation was associated
with correspondingly high nominal money growth. The main cause of high money
growth are high budget deficits. High inflation must be stopped through a stabilization
program. Credible deficit reduction is one of the necessary conditions that must be
fulfilled if high inflation is to be stopped.

b) Budget deficits and money creation

Deficits, seignorage and inflation
The ends of high inflations
Financial crisis and budget deficits

c) A government can finance its budget deficit in one of two ways: It can borrow by
issuing bonds or it can finance the deficit by creating money. Most of the time and
in most countries, deficits are financed primarily through borrowing rather than
through money creation. The revenue from money creation is called seignorage.
Seignorage is equal to the product of money growth and real money balances. High
inflations have to be stopped through a stabilization program. The elements of a
stabilization program are: A fiscal reform and a credible reduction of the budget
deficit. A credible commitment of the central bank that it will no longer automatically
monetize the government debt. Sometimes incomes policies are recommended. The
cause of financial crisis may be so called fundamentals-mainly sustaining budget
deficits.

d) If high inflation is associated with high nominal growth the following question arises:
Why was money growth so high ? The answer turns out to be common to all high
inflations: money growth is high because the budget deficit is high. The budget deficit
is high because the economy is affected by major shocks that make it difficult or
impossible for the government to finance its expenditures.
At the start of high inflation there is a budget crisis. The source is typically a major
social or economic upheaval. If the government´s unwilingness or inability to borrow
from the public or from abroad to finance its deficit increases, the government may
turn to the other source of finance-money creation. The revenues from money creation
are called seignorage. For given real money balances higher seignorage requires
higher money growth. Inflation can be thought of as a tax on money balances. The
product of the rate of inflation (the tax rate) and real money balances (the tax base) is
called the inflation tax. As inflation becomes very high, the budget deficit typically
becomes larger. Part of the reason has to do with lags in tax collection (the Tanzi-
Olivera effect). Thus high inflation typically decreases real government revenues,
making the deficit problem worse. The problem is often compounded by other effects
on the expenditure side. Governments often try to slow inflation by prohibiting firms
under state control from increasing their prices, although their costs are increasing
with inflation. The firms must run a deficit that must in turn be financed by the
government, further increasing the budget deficit.

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 High inflations do not die a natural death. Rather, they have to be stopped through a
stabilization program. What needs to be done to end a high inflation follows from the
analysis of the causes of high inflation. There must be a fiscal reform. This reform
must také place both on the expenditure side and on the revenue side. Further, the
cenral bank must make a credible commitment that it will no longer automatically
monetize the government debt. Some economists believe that incomes policies-that is,
wage and price guidelines or controls-should be used, in addition to fiscal and
monetary measures.
The financial crisis (Asia, Russia and even the Czech republic) can have different
ultimate sources. Some economists argue that these economies were suffering from
serious problems that sooner or later would have led to a crisis. In other words they
point to fundamentals as the ultimate source of the crisis. Other argue that the crisis
was instead largely a case of self-fulfilling expectations. If foreign investors had not
panicked, there would have been no crisis and no reason to panic in the first place.
Both opinions must be carefully scrutinize.

e) High inflation, seignorage, inflation tax, stabilization program, financial crisis

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THE CASE OF RICARDIAN EQUIVALENCE
THEME 7

a) An attack on the traditional Keynesian analysis of fiscal policy was launched by R.

Barro of Harvard university in1974. In order not to be one-sided we pay an attention
to his ideas also. Because Barro´s approach echoed a theme originally proposed by the
classical economist David Ricardo in the early nineteenth century, his point has
become known as the Barro-ricardo equivalence theorem.

b) Today´s holding of government bonds do not represent net wealth

Bequests imply concern about children
Critisism of the equivalence proposition
Evidence from the 1981 tax cuts in the USA

c) Barro´s theory denies the efficacy of discretionary fiscal policy that takes the form of
tax changes. The proposition is that debt financing by bond issue merely postpones
taxation and therefore in many instances is strictly equivalent to current taxation.
Barro´s contribution was to argue that people leave bequests to their children. His
ingenious argument let loose a torrent of critisism. The link between bequests and
concern for children was doubted. Most of the skepticism about the Barro-Ricardian
equivalence theorem emerged immediately after the 1974 publication of Barro´s
article and was based on general principals. However, saving behaviour after 1981-
1983 tax cuts provided additional reason for doubt.

d) The strict Barro-Ricardo proposition that government bonds are not net wealth turns
out on the argument that people realize their bonds will have to be paid off with future
increases in taxes. (Incidentally, after raising this as a theoretical possibility, Ricardo
rejected its practical significance). If so, an increase in the budget deficit
unaccompanied by cuts in government spending should lead to an increase in savings
that precisely matches the deficit. When the government reduces taxes to run a deficit,
the public recognizes that their taxes will be higher in the future. Their permanent
income is thus unaffected by the government´s switch from taxes today to taxes
tomorrow. Their consumption is accordingly also unchanged. Since the tax cut
increased disposable income, but consumption has not risen, saving must rise. The
Barro-Ricardo proposition thus implies that a cut in current taxes that carries with it an
implied increase in future taxes should lead to an increase in saving. The sharp decline
of the U.S. private saving rate in the 1980s is a piece of evidence against the
proposition Less casual empirical research continues in an attempt to settle the issue of
whether the debt is wealth.

e) Equivalence theorem, net wealth, bequests, government bonds

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 SUPPLY SIDE POLICIES
THEME 8

a) Supply side economics predicts that a reduction in marginal income tax rates will
create an increase in the supply of output, that is, in natural real gross domestic
product. The supply side theory makes one uncontroversial statement and two
controversial claims : 1) Income taxes reduce the after-tax reward to work and saving.
2) An increase in the after-tax reward to work and saving would create a significant
increase in the amount of work and saving. 3) The resulting increase in work and
saving would be so significant that after the tax cuts the government would collect
more revenue than before the tax cuts. Supply side economists lay heavy stress on the
incentive effects of taxation in determining the behaviour of the economy.

b) Supply side argument for tax cuts

Response of work effort and saving
The Laffer curve as a topic

c) With the enactment of President Reagan´s budget and tax packages in August 1981,
te stage was set for the most dramatic shift in fiscal policy of the post war era. The
Reagan administration believed that tax rates were simply too high and that the
government sector was too large. High tax rates stifle individual initiative and saving.
Everyone admits that taxes reduce the after-tax reward to work and saving. The
question is if reductions in personal income taxes will lead people to work longer
hours and encourage people to save more. The claim that tax cuts raise government
revenue is also controversial. Nobody can say at what point (the tax rate) on the
Laffer curve maximum revenue occurs.

d) The supply side economists stress the importance of tax incentives in promoting
growth, especially by their effect on saving and investment. Similarly they analyse the
effects of tax changes on labour supply, the effects of social security on saving (see
lecture 5) and retirement decisions and a host of other important issues. In 1981 the
Reagan administration presented an optimistic scenario for growth with low inflation
that was supposedly justified by supply side considerations. Tax rates were to be cut
significantly but, it was claimed, the rapid increase in growth would keep the budget
close to balance. That at least was the public claim.
The most important factor was the President´s determination to cut taxes. This was
done in the belief that the government was too large and that government spending
could be cut by denying Congress tax revenue to spend. Arguments by supply siders
that tax cuts would rapidly increase economic growth and reduce inflation were
certainly welcome. Supply side predictions were critized at the time by mainstream
macroeconomists. The evidence is that tax reductions do affect incentives and that tax
cuts increase output. But there is no evidence that the incentives would be so strong as
to result in higher government revenue after a tax cut. The events of the 2 years
following the Reagan tax cuts do not support the views of the radical supply siders.

e) marginal income tax rates, work effort, the Laffer curve

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FISCAL POLICY AND POLITICAL DECISION MAKING
THEME 9

a) The right mix of fiscal and monetary policy can help a country out of a recession,
improve its trade position without increasing activity and igniting inflation, slow down
an overheating economy, stimulate investment and capital accumulation and so on.
However this is clearly at odds with growing demands that policy makers be tightly
restrained. In the European Union countries that have adopted the Euro are required to
keep their budget deficit under 3% of gross domestic product. In the United States, the
first item in the Contract with America (the program drawn by Republicans for the
mid-term U.S.elections in 1994, was the introduction of a balanced-budget amendment
to the Constitution. Arguments for restraints on policy fall in two general categories:
1) Policy makers may have good intentions, but they end up doing more harm than
good. 2) Policy makers do what is best for them, which is not necessarily what is best
for the country. This lecture develops and examines these arguments in the context of
macroeconomic policy in general and fiscal policy in more detail.

b) Uncertainty and policy

Expectations and policy
Games between policy makers and voters
Games between policy makers

c) A blunt way of stating the argument in favour of policy restraints is that those who
know little should do little. The argument has two parts: first, that macroeconomists
and by implication the policy makers who rely on their advise, know little and second
that they should therefore do little. The macroeconomic policy makers do not operate
in vacuum. They rely in particular on macroeconometric models. But the answers of
the builders of the 12 main macroeconometric models in the USA on a similar set of
questions are different. One reason the effects of macroeconomic policy are uncertain
is the interaction of policy and expectations (lecture 3). So when thinking about policy,
what we need is not optimal control theory as thought in 1970s but rather game theory.
Many macroeconomic measures involve trading off short run losses against long
run gains-or, symetrically, short run gains against long run losses. Tax cuts are often
cited example. Shortsightedness explains much of the past evolution of deficits and
debt. Hard decisions are often delayed. Deficit control and reduction can be achieved
with looser constraints than a constitutional amendment.

d) Macroeconomists are like doctors treating cancer. They know a lot, but there is also a
lot they do not know. If we measure uncertainty by the range of answers from the
different types of macroeconomic models, there is substantial uncertainty about the
effects of policy. This uncertainty should lead policy makers to be more cautios, to use
less active policies. Policies should be aimed broadly at avoiding prolonged
recessions, slowing down booms and avoiding inflationary pressures. What we
develop is an argument for self-restraint by policy makers, not for restraints on policy
makers.
By definition, tax cuts lead to lower taxes today. They are also likely to lead to an
increase in activity and so an increase in pretax income, for some time. But unless they
are matched by equal decreases in government spending, they lead to a larger budget
deficit and to the need for an increase in taxes in the future. If voters are shortsighted,
the temptation for politicians to cut taxes may prove irresistible. Politics may lead to

18
 systematic deficits, at least until the level of government debt has become so high that
politicians are scared into action. A balanced-budget amendment would eliminate the
problem of deficits. But it would eliminate also the use of fiscal policy as a
macroeconomic policy instrument. This is probably too high a price to pay. Deficit
control and reduction can be achieved with looser constraints than a constitutional
amendment.

e) Economic uncertainty, restraints on policy makers, shortsightedness, balanced-budget

amendment

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THE IMPLICATIONS OF THE GOVERNMENT BUDGET
CONSTRAINT
THEME 10

a) This theme is about the long run aspects of fiscal policy. Should the government
budget be balanced every year, on average over the business cycle, or not at all ?
Does a persistent government budget deficit, as has occurred in many advanced
market economies, have adverse economic consequences ? What are these
consequences and are they serious ? Can high budget deficits cause the public debt to
explode ? These questions we shall try to answer in this lecture.

b) Relation between debt, deficits, government spending and taxes

Inflation accounting and the measurement of the deficits
The evolution of the debt to GDP ratio
The dangers of very high debt

c) The government budget constraint links the change in debt to the initial level of debt,
which affects interest payments, and to the current government spending and taxes.
The deficit is decomposed into the sum of two terms-interest payments on the debt
and the difference between spending and taxes, which is called the primary surplus.
Official measures of the budget deficit are constructed as nominal interest payments
plus spending on goods and services minus taxes net of transfers. The correct measure
of the deficit is equal to real interest payments plus government spending minus taxes
net of transfers. The evolution of the level of debt has an economic meaning but in an
economy in which output grows over time, it makes more sense to focus instead on
the ratio of debt to output. There are two costs of high government debt-lower capital
accumulation and higher tax rates and higher distortions. High debt can lead also
tovicious circles nad makes the conduct of fiscal policy extremely difficult.

d) Until now we did not pay in our lectures close attention to the government budget
constraint, that is, to the realtion between debt, deficits, government spending and
taxes. This lecture´s task is to do just that, to look at the government´s budget
constraint and its implications. Correctly we must measure interest payments as real
interest payments-the product of the real interest rate times existing debt-rather than
as actual interest payments-the product of the nominal interest rate times existing
debt. This is the correct way of measuring interest payments. The correct measure of
the deficit is called the inflation-adjusted deficit. For consistency with the definition
of government spending as spending on goods and services these do not include
transfer payments. If the government runs a deficit, government debt increases. If the
government runs a surplus, government debt decreases. The deficit is the sum of the
two terms-interest payments plus primary deficit or surplus. The government can
fully repay the debt or only stabilize the debt. Stabilizing the debt means changing
taxes or spending so that debt remains constant. The change in the debt ratio is equal
to the sum of two terms. The first is the difference between the real interest rate and
the growth rate times the initial debt ratio. The second is the ratio of the primary
deficit to GDP. For the evolution of the debt ratio the most important is the difference
between the growth rate of real GDP and the real rate of interest. The increase in this
ratio will be larger : the higher the real interest rate, the lower the growth rate of
output, the higher the initial debt ratio and the higher the ratio of the primary deficit

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 to GDP. All four factors play a role in the evolution of the debt to GDP ratio over the
last decades in advanced market economies.

e) government´s budget constraint, inflation adjusted deficit, debt to GDP ratio

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STRUCTURAL AND CYCLICALLY ADJUSTED DEFICITS
THEME 11

a) Deficits during recessions should be offset by surpluses during booms, so as not to

lead to a steady increase in debt. To help asses whether fiscal policy is on track,
economists have constructed defcicit measures that tell them what the deficit would
be, under existing tax and spending rules, if output were at its natural level. Such
measures are called structural deficit or cyclically adjusted deficit. Such a measure
gives a simple benchmark by which to judge the direction of fiscal policy.

b) Output stabilization as a short run goal

Structural deficit and its economic meaning
Potential output and the methods of measuring
Automatic stabilizers and their role

c) Measuring productive potential and the position of output in relation to potential are
important elements in economic assessments and provide a number of key insights
into macroeconomic performance. It enables to identify any build-up in underlying
imbalances or structural positions in the macroeconomy. This is particularly important
for fiscal analysis. Changes in the structural deficit may also provide some indication
of the degree of stimulus or restraint that the government wishes to provide to demand
(fiscal impulse) over and above that provided by automatic stabilizers.

d) A variety of methods can be used to calculate trend or potential output and a

corresponding output gap. The best known involves smoothing real GDP using a
Hodrick-Prescott filter, a statistical technique for determining the trend in real GDP by
calculating a weighted moving average of GDP over time. The second approach is to
estimate potential output based on a production function relationship and the factor
inputs that are available to the economy. This requires more data inputs and more
assumptions about economic interrelationships, but is on the other hand less
mechanical and more directly relevant to macroeconomic assessment.
The overall purpose of adjusting government balances for changes in economic
activity is to get a clearer picture of the underlying fiscal situation and to use this as a
guide to fiscal policy analysis. The structural budget balance reflects what government
revenues and expenditures would be if output was at its potential level and therefore
does not reflect cyclical developments in economic activity. In contrast, the actual
budget balance does reflect the cyclical component of economic activity and therefore
fluctuates around the structural budget balance. In practice, the structural budget
balance must be estimated by taking actual government revenues and expenditures and
breaking them into an estimated cyclical component and an estimated structural part.
More precisely, the structural budget balance measures what the balance of tax revenue
less government expenditure would be if actual GDP corresponded to potential GDP.

e) Potential output, structural deficit, smoothing of the cycle

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FISCAL POLICY IN A MONETARY UNION
THEME 12

a) The three essential issues with respect to fiscal policy in European monetary union
are: 1) the debt and deficit criteria as conditions for qualifying for EMU membership; 2)
the need for fiscal discipline and policy coordination in EMU and the role of the criteria in
achieving them; 3) the desirability of creating a supranational fiscal authority in the EU to
accompany monetary union. European economic and monetary union does not envisage
creating a central fiscal authority. Monetary and exchange rate policies will be centralized,
but fiscal policy will remain a national responsibility, in line with subsidiarity principle. A
more active central role could be justified on the grounds of allocative efficiency,
redistribution and stabilization. While in the short term enhanced policy coordination may
adress those pressures satisfactorily, as economic integration proceeds, the case for a
central fiscal authority may become stronger. Pros and cons of the creation of this
authority must be analysed.

b) The basic functions of fiscal policy in a monetary union

Selected features of the largest OECD federations
The EU structural funds
The Maastricht Treaty and the Stability and growth pact

c) After the creation of a common currency, the Euro, European economic and monetary
union does not have a central fiscal authority. Although monetary and exchange rate
policies are fully centralized, fiscal policy remains largely a national responsibility.
Fiscal policies are coordinated through the multilateral surveillance and excessive
deficit procedures of the Maastricht Treaty as clarified in the Stability and growth
pact. As such the EMU policy framework is closer to that of a federation than of a
pure monetary union, although it is one of coordination of fiscal policies rather than
one of a federation comprising a central fiscal authority.

d) Adopting a common currency represents a decisive step for participating members

toward closer integration. The emergence of European public goods, along with
increasing tax competition generated by greater price transparency, however, could
require closer coordination of policies. With increasing factor mobility, redistribution
policies of member states could become ineffective; a more centralized policy, despite
different preferences among countries, may become not only possible but necessary
in the longer run. The absence of an EMU central fiscal authority implies that policy
coordination will continue to rely on existing institutions.
The three basic functions of fiscal policy-allocation, redistribution ans stabilization-
can be assigned differently across levels of governments. In existing federations, the
three basic functions of fiscal policy are carried out largely by central governments,
although with varying degrees of participation from intermediate and local
governments. This is because most of the spending is related to objectives-the
provision of public goods, redistribution and macroeconomic stabilization-that can
not be satisfied adequately by the independent actions of the states or provinces and
because centralization of tax responsibilities is generally more efficient and equitable.
By expressing the presumption that the primary responsibility for public policies in
the Maastricht Treaty lies in the hands of the EU members, the principle recognizes
that countries are not ready to yield more fiscal authority to the EU than they do now.
Allocative efficiency is pursued mainly through the establishment of the single

23
 market. The redistribution and stabilization functions are left largely to member
states, with the EU budget providing for some limited redistribution through
structural funds. The EU budget is financed via a revenue-sharing arrangement with
member states.
The Maastricht Treaty makes the stabilization function the prerogative of each
member state, but subject to multilateral surveillance and excessive deficit
procedures. As a general rule, a government deficit exceeding the reference value of 3
percent of GDP is considered excessive and should be corrected or financial sanctions
will be imposed.

e) Maastricht Treaty, fiscal policy in federation, structural funds, Stability and growth
pact

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FISCAL POLICY IN AN ECONOMY IN TRANSITION
THEME 13

a) Macroeconomic stabilization, price liberalization and privatization are the core

reforms at the beginning of transition. Many fiscal functions as defined in
market economies were carried out during central planning by state enterprises.
The transfer of these functions to the budget will increase budgetary
expenditure and probably also budget deficit. Fiscal and monetary policy are
partially intertwined due to the process of credit creation in the framework of
privatization.

b) Fiscal functions of state firms under a command economy

Budget deficit limits and perverse incentives
Need to separate fiscal from monetary policy
High deficits and needed fiscal reforms

c) One must distinguish public and private finance in a full fledged market
economy. Under socialism many fiscal functions were carried out by state
enterprises.The transfer of these functions to the budget will increase
budgetary expenditures. Focusing on budget deficit at the beginning of
transition is not the main tast of economic policy. Budget deficit is influenced
through unemploymenz policy, the exchange rate policy and by using
extrabudgetary accounts. Structural reforms and total credit expansion must
receive the full attention in the further phase of transition

d) During central planning it was not really meaningful to speak of fiscal policy
and public finance since these concepts imply the existence of private finance
and thus a significant private sector. In that era all was public in a way. The
state enterprises often provided to their workers housing, hospital care,
vocational training, kindergartem facilities, shops, pensions, various forms of
welfare assistance, employment and so forth. Because the state enterprises
were required to hire workers even when they did not neen them, official
unemployment was nonexistent. But delaying the transfer of these functions to
the government would slow down the process of transformation. It is better
policy to subsidize the enterprises through the budget than through soft and
cheap loans from the banking system. Later these soft loans must be paid
through the state budget also-see the czech case. Under higher inflation at the
beginning of transition the primary deficit is a useful concept, which attempt to
eliminate the impact of inflation on the deficit. Should the government be
excessively concerned about the size of its budget deficit, it may encourage the
state enterprises to continue hoarding workers. Rigid ex ante limits on the
measured size of the deficit might encourage the authorities to delay the
needed exchange rate adjustment. What is the most important is to continue
with structural reforms at the level of enterprises and to diminish the abundant
mandatory expenditures

e) The transfer of functions, quasi fiscal deficit, true fiscal deficit

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