Automatic stabilizers

Automatic stabilizers refer to the built-in fiscal devices ensuring deficit in recession and suplus during booms. Automatic stabilizers can minimize the timing problem.

Progressive income taxes

• Drop out from tax rolls during downturn and add to it during booms

Corporate taxes

• Taxes on corporate profits go up substantially during boom times, and decline rapidly during times of recession.

Unemployment benefits (need- tested spending)

• More money is paid out when more people is unemployed.

Discretionary fiscal policy

During recession, government increase spending and/or reduce taxes to stimulate aggregate demand.

During inflation, government reduce spending and/or increase taxes to restrain aggregate demand.

Limitations of discretionary fiscal policy

• Recognition lag - the time difference between the need for a fiscal policy shift and when policy makers recognize it
• Administrative lag - the time difference between recognition of the need and when the policy shift is implemented
• Impact lag - the time difference between implementation of the policy shift and its impact on the economy

Expenditure multiplier, Tax multiplier, Balanced budget multiplier

Expenditure (Government Purchase) Multiplier
Increase in government expenditure => workers and captial owners receive wages or payments => increase in aggregate expenditures

Tax Multiplier
Increase in taxes => decrease in income => decrease in consumpton expenditures

Balanced budget multiplier
As expenditure multiplier is stronger than tax multiplier, equal increase in expenditure an tax will lead to increase in GDP.

The generational effects of fiscal policy

Current fiscal policy impacts the amount of taxes that future citizens will pay. This situation is referred to as generational imbalance.

In case of long-term budget deficits, future generations will need to pay higher taxes in order to pay the interest.

In case of budget surpluses, future generations will pay lower taxes.

Generational accounting
Economists have created systems which examine the lifetime taxes and benefits associated with generations or age groups. Those systems are referred to as generational accounting.

Crowding-out effect and other Influences

Crowding-out effect
It occurs when budget deficits caused by expansionary fiscal policy lead to higher interest rate and lower private investment.

Government borrowing => increase demand for loanable funds => increase real interest rate => reduce profitability of investment projects => lower private investment => reduce the impact of expansionary fiscal policy on aggregate demand => inefficient public sector crowding out efficient private sector without any gain in GDP

Government spending =>shift aggregate demand =>budget decficit =>increase demand for loan =>increase interest rate, lower private investment =>adjust AD back

Note:
Unlike Keynesian model, prices are flexible Under classical economist’s view.

Keynesian model
It recommends that fiscal policy should be used (countercyclical policy) to smooth the business cycle. Expansionary fiscal policy to help the economy out of recessions and boost employment. Restrictive fiscal policies to rein in aggregate demand when the economy is growing too fast.

Some economist’s view
Deficit spending =>increase interest rate =>attract foreign investment =>increase loanable fund =>reduce interest rate =>offset crowding out effect

Increase saving =>increase loanable fund => interest rate unchanged

Increase foreign investment=>appreciate dollars=>increase imports decrease exportàtrade deficit and budget deficit

New classical model
Expansionary fiscal policy => budget deficits and debt => private individuals realize that taxes will eventually increase and so increase saving => fall in private consumption =>negates the rise in government spending and hold AD constant

Summary: If tax cut, no change in output, price, interest rate, unemployment => ineffective

Note:
Tax cut increase saving but no spending, opposite to Keynesian view that tax cut cause increase in disposable income =>increase consumption

Supply side model:
Governments should fuel economic growth by promoting supply rather than demand. Lower marginal tax rates => increase in efficient private sector investment => higher incomes => increased tax receipts despite lower tax rates.

Emprical evidence
Fiscal policy:
Countercyclical due to automatic stabilizer rather than actively change fiscal policy.

Budget deficits and real interest rates:
According to the crowding out model, deficits leads to higher demand for loanable funds and thus higher real interest rates. However, any rise in real interest rates increases the supply of capital from home and abroad. Empirical evidence suggests that the link between the two is very weak and crowding out effect is mixed.

Budget deficits and trade deficits:
Deficit leads to inflow of foreign capital flows and thus appreciate domestic currency and causes influx of imports, higher trade deficit is resulted at last.

Inflation:
Little support budget deficit cause inflation

Sources of investment finance

Sources of investment finance includes:

• Private saving
• Government saving
• Borrowing from foreigners

Capital markets are influenced by fiscal policy in two ways:

• Government spending and tax policy will generate either a budget surplus or a deficit, which will in turn contribute towards financing investment or "crowd out" private investment.
• Tax policy will affect the amount saved. Taxes on interest earned will decrease the incentive to save.
  

Laffer curve

The Laffer curve shows the relationship between tax rates and tax revenue.

As the tax rate increases from zero, the amount of tax revenue collected will increase. But after a point where potential GDP is maximized, increases in the tax rate lead to decreases in the tax revenue collected. High tax rates also produce a loss to society in the sense that productive economic activity is being discouraged.

Fiscal Policy and Potential GDP

Fiscal policy
Fiscal policy refers to the use of government taxation, spending and borrowing to satisfy macroeconomic goals.

Three major ways that fiscal policy to increase aggregate demand:
Lower business tax - can change the profitability of businesses and the amount of business investment.
Increase government spending
Lower tax for individuals - increase disposable personal income and increase consumption spending.

Fiscal policy has an advantage over monetary policy as increase in government spending leads to an immediate increase in aggregate demand. However, the effects of a tax cut may be more moderate and have more of a time lag because individuals may not immediately spend their increases in disposable income that resulted from the tax cut.

Potential GDP
The GDP resulted from an economy operating at full employment with full utilization of capital is called potential GDP.

Supply-side effect
The effects of the changes in fiscal policy on aggregate supply is called supply-side effect.

Increase in taxes on expenditures and/or income => less labour supplied => supply curve shift up to the left=> reduce aggregate supply of labor, real GDP and potential real GDP.