Demand management: fiscal policy

📚The economics

Government revenue and expenditure

If spending exceeds revenue in a year, the government runs a budget deficit, financed by borrowing; if revenue exceeds spending, a surplus. Accumulated deficits form government debt (3.3).

Goals of fiscal policy

Fiscal policy shares the macro goals of monetary policy (low and stable inflation, low unemployment, a stable environment for growth, smoothing the business cycle, external balance) and adds one monetary policy cannot easily reach: an equitable distribution of income, through progressive taxes, transfers and public services (3.4).

Expansionary and contractionary fiscal policy

The two schools disagree about how much fiscal policy can achieve:

• Keynesian: in a recession there is plenty of spare capacity, so higher G raises real output and employment with little inflation, and the multiplier magnifies the effect. Governments should actively use fiscal policy.
• Monetarist/new classical: the economy returns to full employment anyway; in the long run higher AD just raises the price level (vertical LRAS). Deficits also crowd out private investment. Fiscal policy should aim for balanced budgets and sound finances.

The Keynesian multiplier HL

An injection of spending (G, I or X) raises national income by more than the initial amount, because one person’s spending is another’s income. When the government pays construction firms, workers receive wages and spend part of them, those shopkeepers spend part of that, and so on. At each round some income leaks out as saving, taxes and imports.

• MPC (marginal propensity to consume) is the fraction of extra income spent on domestic output; MPS, MPT and MPM are the fractions of extra income saved, taxed and spent on imports. MPC + MPS + MPT + MPM = 1.
• The larger the leakages, the smaller the multiplier. Open economies that import a lot, and economies with high taxes, have smaller multipliers.
• The multiplier also works in reverse: a fall in investment or exports reduces GDP by a multiple.

Crowding out HL

If the government borrows to fund a deficit, it competes with private firms and households for the available supply of loanable funds (savings). Demand for loanable funds rises, real interest rates rise, and some private investment and consumption that would have happened is crowded out. So the net rise in AD is smaller than the rise in G. Monetarists see crowding out as strong; Keynesians argue it is weak in a recession, when saving is plentiful and private investment is low anyway.

Automatic stabilizers HL

Some fiscal effects happen automatically, without any new decision:

• Progressive income taxes: in a boom, incomes rise and people move into higher tax bands, so tax revenue rises faster than income, slowing spending growth. In a recession, tax payments fall faster than income, cushioning disposable income.
• Unemployment benefits: spending rises automatically as unemployment rises in a recession, supporting consumption, and falls in a boom.

They reduce the size of fluctuations with no time lag for decision-making. They are weaker in countries with small formal tax bases and limited benefit systems.

How effective is fiscal policy?

Constraints:

• Political pressure: governments find it easy to spend and cut taxes before elections, hard to do the reverse in a boom, so fiscal policy is often too loose (a deficit bias).
• Time lags: recognizing the problem, passing a budget, and implementing projects (infrastructure takes years) mean stimulus may arrive after the recession is over.
• Sustainable debt: countries with high debt, or which borrow in foreign currencies, face rising interest costs and credit-rating downgrades; Indonesia’s legal 3%-of-GDP deficit ceiling limits room for stimulus.
• HL Crowding out reduces the net effect on AD.
• Tax cuts may be saved rather than spent if confidence is low; leakages reduce the multiplier.

Strengths:

• Can target specific sectors and regions (tourism in Bali after the pandemic, infrastructure in eastern Indonesia) and specific groups (cash transfers to the poor), and can promote equity.
• Effective in a deep recession, when monetary policy is stuck at low interest rates and confidence is low: government spending directly creates demand whatever households and firms do.
• Capital spending on infrastructure and education also raises long-run productive capacity (a supply-side effect, 3.7).
• HL Automatic stabilizers work without lags.