Page 296-till end chapter 11
Economics and Business (EBC1009)
Maastricht University
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Page 296 till the end of chapter 11
Chapter 11: Expenditure and fiscal policy
Fiscal policy weaknesses
Automatic stabilizers enable the economy to adjust automatically to changes in aggregate demand.
Assumption:
During a boom:
- Income increases
- Tax receipts will increase
- Savings will increase
- Government will cut back on social payments
This means that the economy has automatic brakes built into the system that help to regulate the economic boom,
During a recession:
- Tax savings will reduce
- Government payments will increase
This way the economy will automatically reduce the net rate of leakages and help to keep the economy moving.
From a fiscal position, the economy can be placed on autopilot and there is no need for the government to overly monitor and make policy changes.
Fiscal policy and implementation problems
Active fiscal where the government seeks to pursue an expansionary or contractionary, fiscal policy can be problematic. These problems are:
Time lags A time lag is an interval of time between two related phenomena (such as a cause and its effect) To actively manage fiscal policy the government needs to know when aggregate demand is falling and when it is rising. This can be achieved by a lag. Government use statisticians to collect data on the economy. Sometimes the data is not given on time, that causes government to react with policy that can be inappropriate for that time which cause a negative effect on the economy.
Uncertainty In practice, governments do not know the exact values for example equilibrium level of output, current level of output and the size of the multiplier. The governments uses estimates which could involve uncertainty.
1 merriam-webster/dictionary/time%20lag
- Offsetting An offset involves assuming an opposite position in regards to the original opening position2. For example, in the presence of large mountains of public debt, sensible private individuals may predict that in the future tax rates will have to rise in order to fund the current lax fiscal position of the government. In order to offset these future higher taxes, individuals might save more.
Deficits and inflation
Inflation can erode the amount of debt. A private individual has very little control over the rate of inflation. If a government runs up a mountain of debt, the temptation to let the rate of inflation increase and erode the real value of the debt is very tempting.
This has two important implications:
- If the government is trying to manage individuals inflationary expectations, then it needs to manage the size of the government debt
- Within a fixed exchange rate system such as the European single currency, harmonizing inflation across member states may aid economic convergence among those states. Therefore as entry into the system draws nearer, the UK needs to bring fiscal policy under control.
Crowding out
Crowding out occurs when increased government spending reduces private sector spending.
Foreign trade and aggregate demand
Exports are generally expressed as X.
Imports are expressed as Z.
Net exports or trade balance = Exports minus imports (X-Z)
If exports are greater that imports, the economy has a trade surplus.
If imports are greater than exports, the economy has a trade deficit.
Aggregate demands can be defined as Consumption + Investments + Government Spending + Net exports (C+I+G+ (X-Z))
Factors that determine exports and imports:
- The level of income of the UK for example does not influence exports, instead US consumers’ willingness to purchase from the UK is influenced by US income. Exports are autonomous or independent of UK’s level of income.
- The level of income influences imports. As our income increases, we are willing to buy more expensive products from overseas.
2 investopedia/terms/o/offset.asp
Business application: Taxation of government spending.
A fiscal stimulus can occur through increased government spending or a reduction in tax. Both approaches increases total expenditure.
Timing
Planned expenditure is defined by the government announcing huge increases in expenditure. It takes time to prepare the expenditures because they need to me highlighted designed, contract and executed.
Channels of spending
Government spend on projects such as education, health care and transport. Infrastructure projects in these areas are very attractive.
If fiscal policy involves tax cuts, then consumers can spend money on the markets they find most desirable. Markets are generally accepted as the most effective means of solving the problem of infinite wants and finite resources.
Why, during a recession, should we sacrifice this view and suddenly believe that governments are better placed to decide where spending should occur? Because of the following:
- Consumers may not react to tax cuts. They may instead save the additional income
- In an economy that has a high propensity to import, tax cuts are unlikely to fuel an increase in domestic demand.
Because of before mentioned reasons the government spending may be preferable because it ensures that spending occurs and that it occurs within the economy.
Understanding the difference between tax cuts and government spending enables the understanding of the likely time it will take to stimulate the economy and determine which sectors will be winners and losers.
Business data application: Understanding the fiscal position and the
implications for business
In nearly all for economies (France, Germany, Greece and the UK) the start of the crisis in 2008 and the onset of the global recession marks a swift in deterioration in the state of government finances.
While the recent global recession gas played a role in the growth of government debt, it is not the only reason, nor indeed, perhaps the most important reason.
If government borrowings increase during a period of economic growth, then the expansion of government debt is structural not cyclical. Cyclical deficits should reduce as ab economy begins to recover from a recession, tax revenues rise and transfer payments. However structural deficits will persist, unless there is strong government action to cut spending and raise taxation further
Reductions in government spending will reduce aggregate expenditure and therefore GDP. Any fiscal multiplier effect will only serve to amplify the reduction in GDP. Equally, increased
taxation will reduce households incomes and that in turn will lead to a fall of consumer spending.
Understanding in concepts linked to fiscal policy and government debt, enables business managers to have a stronger appreciation of how the business environment and the broader economy are linked to deficit reduction policies.
Importantly, a significant amount of government deficits is structural, not cyclical, meaning that the government cannot rely on a growing economy to correct high fiscal deficits.
Austerity 3 plans aimed at reducing government spending and raising tax are necessary; and such policies will act as a drag (movement) on overall economic output.
3 difficult economic conditions created by government measures to reduce public expenditure.
Page 296-till end chapter 11
Vak: Economics and Business (EBC1009)
Universiteit: Maastricht University
