FISCAL POLICY

• Consists of changes in government spending (G) and tax collections

(T) to achieve macroeconomic goals
Public sector deficits or surpluses
The government’s fiscal stance

Policy setting
• Formulated and implemented by Finance Minister
• G and T have to be approved by parliament
 FISCAL POLICY
Approaches to the implementation

Discretionary fiscal policy (active)

• implementation at the option of the government according to its
target objectives
• Changing government expenditure and taxes depending on the state
of the economy
• E g reducing T during a recession. Government uses its discretion
Approaches to implementation

Automatic fiscal stabilizers (passive)

• A second type of fiscal policy is built into the structure of government
T and spending
• Tax stabilizers (PAYE)
• Benefits stabilizers (pension; AIDS levy)
These both act to increase AD in recessions, and to decrease AD in
overheated expansions
 The Basic Theory of Fiscal
Stabilization
• How fiscal stabilization works?
• Designed to reduce the economy’s cyclical fluctuations :-
-recessionary gap
-inflationary gap
• G and T affect both AS and AD
• FP :
a) Closing a recessionary gap
-what is a recession? What causes it?
Fiscal Policy – expansionary fiscal policy
What fiscal policy should be adopted to stimulate the economy?

Three ways to close the recession gap

• Private sector demand recovers
• Excess supply of factors causes wages and other factor prices to fall
-process take long due to stickiness of wages
-(a) and (b) –is self correction (market forces)
Calls for government intervention to stimulate AD (Keynesian economics)
 FISCAL POLICY
• Government uses expansionary fiscal policy
-government cannot wait for the recessionary gap to correct itself
Illustration
• Increase in G or tax cuts pushes the economy out of a recession.
• GDP
 FISCAL POLICY
• Advantage: - shorten what might be a long recession
• Disadvantage:
• FP may stimulate the economy just before the private sector spending
recovers on its own.
• As a result economy may overshoot its potential output. (inflationary
gap)
• Thus FP intended to promote economic stability can actually cause
instability
 FISCAL POLICY
• An expansionary FP creates a budget deficit
• Analyze contractionary FP in closing an inflationary gap
• Contractionary FP creates a budget surplus
• Deficits and surpluses are burden to the govt that can cause serious
economic problems
• The expansionary effect of seficit spending depends on the method
used to finance the deficit
• The anti-inflationary effect or surplus depends on how the surplus is
disposed
Financing of deficits and
disposing of surpluses
Financing a debt
a) Borrowing from the public
-govt enters the money market and borrows
-it will compete for funds with private business borrowers
-this will drive up interest rates and crowd out pvt investment and consumer
spending
Any decline in pvt spending will weaken the expansionary effect of the deficit
spending
Adv- it is not potentially inflationary
Disadv- risk of accumulating gvt debt (debt trap)
Financing of deficits and
disposing of surpluses
Financing a debt
b)Money creation
-CB prints money to finance a deficit (seigniorage revenue)
Adv- crowding effect is avoided
I e G can increase without adversily affecting I and C
Disadv- it can however be more inflationary
• Disposing of surpluses can be handled in 2 ways
• Debt reduction
-money is transferred back to the money market, I fall and borrowing
and spending rise (AD)
-this could be inflationary
• Idle surplus (impounding)
-holding idle surplus
-gvt is extracting and withholding purchasing power from the economy
-no possibility for the surplus to create inflationary pressure that off-set
the anti-inflationary effect or contractionary FP
Effectiveness of fiscal policy
Discretionary policy:
• Timing
-long administrative lag. Economic situation will have changed by time of
approval, rendering the policy prescription ineffective
-however shorter operational lags as compared to MP e g tax reductions, G on
public works
• Political business cycles
-politicians will manipulate FP to maximize voter support even though the
decision destabilizes the economy
E g subsidies, tax cuts, Increase in G towards elections populist policies
 Effectiveness of fiscal policy
• Crowding effect
-deficit spending forces IR to rise thereby chopping off pvt investment
-FP may be largely ineffective
• Unforeseen events
-droughts
-diseases (pandemic e g cholera)
-war
-all these render tight FP ineffective.
Effectiveness of automatic stabilizers
• The problem of fiscal drag
-the process by which rising incomes draw people into higher tax
brackets, so that their real incomes may fall, this acts as a restraint on
the expansion of the economy.
 Monetary and Fiscal Policy
• Policy complementary
-tight MP must be accompanied by tight FP
-all policies must be designed to achieve the same goals