Transcript BD104_fme_lnt_004_Ma..

LECTURE 4
Fiscal Policy
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The Multiplier Revisited
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Changes in one or another of the components of
total spending C, I, G or NX will change the
equilibrium GDP by a larger amount.
Fluctuations in any of these - C, I, G or NX occur
all the time. If the multiplier is smaller, GDP will
be less sensitive to such shocks; that is, the
economy will be less volatile.
Automatic Stabilizers
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Features of the economy that reduces its
sensitivity to shocks are called automatic
stabilizers.
Example: Income tax. It acts as a shock absorber
because it makes disposable income, and thus
consumer spending, less sensitive to fluctuations
in GDP.
Income Tax as an Automatic
Stabilizer
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Suppose Firm A spends RM1 million on salaries.
Assume that the government levies a 20% income tax.
This means that workers only receive RM800,000 in
after-tax income (also known as disposable income).
If MPC is 0.75, spending in the next round will only be
RM600,000; which in only 60% of the original
expenditure because of the income tax.
Built-In Stabilizers
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A built-in stabilizer is anything that increases
the government’s budget deficit (or reduces its
budget surplus) during a recession and increases
its budget surplus (or reduces its budget deficit)
during inflation without requiring explicit
action by policymakers.
Government Expenditures (G)
and Tax Revenue (T)
T
Surplus
G
Deficit
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GDP1 GDP2
GDP3
Gross Domestic Product
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From the graph above, tax revenues (T) vary
directly with GDP, and government spending G
is assumed to be independent of GDP. As GDP
falls in a recession, deficits occur automatically
and help alleviate the recession. As GDP rises
during expansion, surpluses occur automatically
and help offset possible inflation.
Fiscal Policy
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The government’s fiscal policy is its plan for
spending and taxation.
The government will take these actions to reach
certain goals such as full employment, price
stability and economic growth.
There are two types of fiscal policy:
(a) expansionary fiscal policy.
(b) contractionary fiscal policy.
Expansionary Fiscal Policy
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An expansionary fiscal policy is defined as:
(a) an increase in government expenditures or
(b) a decrease in in taxes.
This is done with an aim to increase budget
deficit or decrease budget surplus.
Contractionary Fiscal Policy
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A contractionary fiscal policy is defined as:
(a) a decrease in government expenditures or
(b) an increase in taxes.
This is done with an aim to decrease budget
deficit or increase budget surplus.
Fiscal Policy to Eliminate
Recessionary Gap
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Real Expenditure (RM billions)
Potential GDP
C + I + G + NX
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Recessionary Gap
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6,000
7,000
Real GDP (RM billions)
Real Expenditure (RM billions)
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Potential GDP
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C + I + G + NX
C + I + G + NX
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6,000
7,000
Real GDP (RM billions)
Problems and Critiques of Fiscal
Policy
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Problems of timing
Political considerations
Future policy reversals
Offsetting state and local finance
Crowding-out effect
Problems of Timing
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Recognition lag
(a) This is the time between the beginning of
recession or inflation and the certain
awareness that it is actually happening.
(b) It arises because of the difficulty in predicting
the future course of economic activity.
Administrative lag
There will typically be a significant lag between the time the need for
fiscal action is recognized and the time action is taken.
Operational lag
A lag also occurs between the time fiscal action is taken and the time
that action affects output, employment, or the price level.
Political Considerations
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A strong economy at election time might
politicians.
Eg. Politicians might favor large tax cuts under
the guise of expansionary fiscal policy even
though that policy is economically inappropriate.
Future Policy Reversals
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Fiscal policy may fail to achieve its intended
objectives if households expect future reversals of
policy.
Eg. Tax cuts. If taxpayers believe the tax reduction
is temporary, they may save a large portion of
their tax saving, reasoning that rates will return
to their previous level in the future.
Offsetting State and Local Finance
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The fiscal policies of state and local governments
are frequently pro-cyclical, meaning that they
worsen rather than correct recession or inflation.
Crowding-Out Effect
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An expansionary fiscal policy (deficit spending)
may increase the interest rate and reduce private
spending, thereby weakening or canceling the
stimulus of the expansionary policy. In this view,
fiscal policy may be largely or totally ineffective!