Showing posts with label Fiscal policy. Show all posts
Showing posts with label Fiscal policy. Show all posts
Problems in recovering from a recession
To recover from a recession there needs to be either a rise in AD or a readjustment in prices and wages.
Classical economists argue that a recession will only be temporary because labour and product markets are flexible. However Keynesians argue that wage and price rigidity can keep the economy below full capacity for a long time.
For example to regain equilibrium it may be necessary to reduce prices and therefore reduce nominal wages by an equivalent amount. However this may be difficult because trades unions will resist cuts in nominal wages, also firms would be willing to cut wages because it may lead to lower productivity amongst workers.
- Low Consumer confidence.
In a recession there will be rising unemployment and therefore a fall in consumer confidence. This will cause a rise in the savings ratio. In other words, people will spend less of their disposable income and save more leading to a bigger fall in AD. If confidence remains very low for a long time then it will be difficult for the govt to increase AD. For example, if the govt cut income taxes this would increase disposable income, but if confidence was low people would not be willing to spend any extra and the economy would remain in a recession.
- Ineffectiveness of Monetary Policy.
In a recession the Bank of England could cut interest rates to stimulate demand. Lower interest rates reduce the cost of borrowing and therefore people should be more willing to spend and invest. However, Monetary policy could be ineffective. Firstly, firms may be reluctant to invest, even though it is cheap to borrow because they cannot see any increase in demand. If a country is a member of the EURO it may make it more difficult to increase AD in a recession. This is because interest rates will be set by the ECB and the UK would lose control over interest rates. Interest rates may be too high if the UK is in a recession and other countries in the Euro zone are growing.
- Effectiveness of Fiscal Policy.
Keynesians argue that expansionary fiscal policy can be used to increase AD and get the economy out of a recession. However, there may be many problems of using fiscal policy to increase AD.
- Firstly there will be time lags. It takes time for the govt to change its spending plans and once implemented it will take time for this spending plan to actually increase AD
- Also increasing AD may cause crowding out. This means that if the govt increases its spending then it will lead to a corresponding fall in private sector spending. This is because the govt borrows off the private sector to finance its spending. However Keynesians reject this argument saying that the govt will only be using previously unemployed resources therefore there will be no crowding out.
- Deflation.
If there is deflation this makes it difficult to increase demand. This is because people will not spend if they feel that prices will be cheaper in the future. Also, Monetary policy will become ineffective because interest rates cannot fall below 0% therefore with deflation real interest rates may remain high. E.g. Japan has experienced deflation during the 1990s and this made it very difficult to increase AD and economic growth.
- Hysteresis.
This states that what has happened in the past will affect the future. For example if unemployment is high then it is likely to continue being high. If people are unemployed for a long time they become de-motivated and less employable because they are now less skilled (less on the job training). Also if productive capacity is not used for a long time then it firms will shut factories down completely, causing a fall in AS. Therefore in a prolonged recession there will be not just a fall in AD but also a fall in AS causing a permanent fall in the potential output of an economy. This occurred during the Great depression of the 1930s.
- Supply side shocks.
If there was a fall in AS as well as AD this would make the recession more severe. For example if there was a rapid rise in the oil price like in the 1970s then AS would shift to the left causing lower growth and higher inflation.
Fiscal Policy
Fiscal policy is the deliberate alteration of government spendingor taxation to help achieve desirable macro-economic objectives by changing the level and composition of aggregate demand (AD).
Types of fiscal policy
There are two types of fiscal policy, discretionary and automatic.
- Discretionary policy refers to policies which are decided, and implemented, by one-off policy changes.
Fiscal boost
Similarly, a potentially rapid and deep decrease in national income would be prevented by fiscal boost. Fiscal boost means as incomes fall in a recession the impact of falling incomes for the better off is softened as they pay proportionately lower taxes, and retain more post-tax income.The impact of falling income is to increase unemployment, but rather than experience a complete collapse in personal income, the unemployed, and the poor, receive benefits, and spend more than they would have without such benefits. Hence, a downturn in the economy is also ‘moderated’
Fiscal policy and Aggregate Supply
Fiscal policy can have important effects on the supply-side of developed and developing countries.
Labour market incentives:
- Changes in income tax can improve incentives for people to actively look for work
- Lower taxes might also have a positive effect on work effort and labour productivity
2.Capital spending:
- Spending on infrastructure provides the capacity needed for other businesses to flourish.
- Lower rates of corporation tax might attract inward investment from overseas
3.Entrepreneurship and investment:
- Government spending can be used to fund an expansion in new small business start-ups
4.Research and development and innovation
- Government spending and tax allowances could be used to encourage research
- Tax incentives can be used to stimulate investment in low carbon technologies
5.Human capital of the workforce:
- Spending on education and increased investment in health and transport can also have important supply-side effects in the long run
- Government spending can help to improve human capital, employability and productivity
Fiscal policy
A decade ago, the prevalent view about fiscal policy among academic economists could be summarised in four admittedly stylised principles:
- Discretionary fiscal policy is dominated by monetary policy as a stabilisation tool because of lags in the application, impact, and removal of discretionary fiscal stimulus.
- Even if policymakers get the timing right, discretionary fiscal stimulus would be somewhere between completely ineffective (the Ricardian view) or somewhat ineffective with bad side effects (higher interest rates and crowding-out of private investment).
- Moreover, fiscal stabilisation needs to be undertaken with trepidation, if at all, because the biggest fiscal policy priority should be the long-run fiscal balance.
- Policymakers foolish enough to ignore (1) through (3) should at least make sure that any fiscal stimulus is very short-run, including pulling demand forward, to support the economy before monetary policy stimulus fully kicks in while minimising harmful side effects and long-run fiscal harm.
Today, the prolonged aftermath of the Global Crisis, the increased realisation that equilibrium interest rates have been declining for decades and a better understanding of economic policy from the last eight years of experience have led the shift away from this ‘Old View’ of fiscal policy.1
Theory and evidence for the New View of fiscal policy
The New View of fiscal policy largely reverses the four principles of the Old View – and adds a bonus one.
- First, fiscal policy is often beneficial for effective countercyclical policy as a complement to monetary policy.
With low interest rates limiting the effectiveness of conventional monetary policy, central bankers and international organisations increasingly endorse the idea that monetary policy cannot, by itself, be fully effective and would benefit from supportive fiscal policy
Fiscal policy
In order to learn and understand fiscal policy or monetary policy it is important to whether an economy, no matter where it may be in the world, can self regulate, or whether it needs an outside influence in order to adjust. This is where Classical and Keynesian economics will come into play. If you are of the Keynesian school of thought, you believe that the economy needs your influence in order to correct itself. This correction can be in the form of fiscal policy.
Fiscal policy can be defined as government�s actions to influence an economy through the use of taxation and spending. This type of policy is used when policy-makers believe the economy needs outside help in order to adjust to a desired point. Typically a government has a desire to maintain steady prices, an employment level, and a growing economy. If any of these areas are out of sorts, some type of fiscal policy may be in order.
Fiscal policy can be used in order to either stimulate a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control (which can lead to inflation or asset bubbles). Fiscal policy directly affects the aggregate demand of an economy. Recall that aggregate demand is the total number of final goods and services in an economy, which include consumption, investment, government spending, and net exports.
Aggregate Demand = Consumption + Investment + Govt Spending + Net Exports
Fiscal policy has an effect on each of these categories. There are two types of fiscal policy: Expansionary and Contractionary.
Expansionary Fiscal Policy
When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap � meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.
Contractionary Fiscal Policy
Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing too fast or for example, if unemployment is too low, an inflationary gap will form. In order to eliminate this inflationary gap a government may reduce government spending and increase taxes. A decrease in spending by the government will directly decrease aggregate demand curve by reducing government demand for goods and services. Increases in tax levels will also slow growth, as consumers will have less money to consume and invest, thereby indirectly reducing the aggregate demand curve.
Fiscal Policy Summary
To summarize, fiscal policy is a type of economical intervention where the government injects its policies into an economy in order to either expand the economy�s growth or to contract it. By changing the levels of spending and taxation, a government can directly or indirectly affect the aggregate demand, which is the total amount of goods and services in an economy.
One thing to remember concerning fiscal policy is that a recession is generally defined as a time period of at least two quarters of consecutive reduction in growth. It may take time to even recognize whether or not there is a recession. With fiscal policy, there will be certain levels of lag time in which conditions will deteriorate before being recognized. At the same time, fiscal policy takes time to implement due to legislative and administrative processes, and those same policies will take time to show results after implementation.
Consumers can also react to these policies positively or negatively. Most consumers would have a positive reaction per say to a policy that lowers taxes, while some will have an issue with a government spending more which will increase the burden of debt on nations citizens.
Nevertheless, fiscal policy is a type of intervention that can help to control the direction of an economy. Deciding if and when it should be used will certainly continue to be debated.
What is the right fiscal policy?
What is the right fiscal policy? People differently placed on the politico-economic spectrum will give you radically different answers.
At one extreme, you have the hairshirt fiscal purists who think government borrowing is always wrong and who won’t be happy until all that debt has been repaid. At the other, you have the Keynesian fundamentalists who believe that the Government can carry on borrowing until the cows come home.
A lifetime in economics has taught me that the right fiscal policy changes with circumstances. And ours have been through a revolution.
The Return of Fiscal Policy
Since the global financial crisis of 2008, monetary policy has borne much of the burden of sustaining aggregate demand, boosting growth and preventing deflation in developed economies. Fiscal policy, for its part, was constrained by large budget deficits and rising stocks of public debt, with many countries even implementing austerity to ensure debt sustainability. Eight years later, it is time to pass the baton.
As the only game in town when it came to economic stimulus, central banks were driven to adopt increasingly unconventional monetary policies. They began by cutting interest rates to zero, and later introduced forward guidance, committing to keep policy rates at zero for a protracted period.
In rapid succession, those in advanced economies also launched quantitative easing (QE), purchasing huge volumes of long-term government securities to reduce their yields. They also initiated credit easing, or purchases of private assets to reduce the costs of private sector borrowing. Most recently, some monetary authorities – including the European Central Bank, the Bank of Japan, and several other European central banks – have taken interest rates negative.
These policies boosted asset prices and economic growth while preventing deflation, but they are reaching their limits. In fact, negative policy rates may hurt bank profitability and thus banks’ willingness to extend credit. As for QE, central banks may simply run out of government bonds to buy.
Yet most economies are far from where they need to be. If below-trend growth continues, monetary policy may well lack the tools to address it, particularly if tail risks – economic, financial, political, or geopolitical – also undermine recovery. If banks are driven, for any reason, to reduce lending to the private sector, monetary policy may become less effective, ineffective or even counterproductive.
In such a context, fiscal policy would be the only effective macroeconomic policy tool left, and would have to assume much more responsibility for countering recessionary pressures. But there is no need to wait until central banks have run out of ammunition. We should begin activating fiscal policy now, for several reasons.
Thanks to painful austerity deficits and debts have fallen, meaning that most advanced economies now have some fiscal space to boost demand. Central banks’ near-zero policy rates and effective monetisation of debt by way of QE would also enhance the impact of fiscal policy on aggregate demand. Long-term government bond yields are at a historic low, enabling governments to spend more and/or reduce taxes while financing the deficit cheaply.
Most advanced economies need to repair or replace crumbling infrastructure, a form of investment with higher returns than government bonds, especially today, when bond yields are extremely low. Public infrastructure not only increases aggregate demand. It also increases aggregate supply, because it supports private-sector productivity and efficiency.
The good news is that the advanced economies of the G7 seem poised to begin – or perhaps have already begun – to rely more on fiscal policy to bolster sagging economic growth, even as they maintain the rhetoric of austerity. In Canada, prime minister Justin Trudeau’s administration has announced a plan to boost public investment. His Japanese counterpart, Shinzo Abe, has decided to postpone a risky consumption-tax hike planned for next year, while also announcing supplementary budgets to increase spending and boost the household sector’s purchasing power.
The UK’s new government, led by Theresa May, has dropped the target of eliminating the deficit by the end of the decade. In the wake of the Brexit vote, her government has designed expansionary fiscal policies aimed at spurring growth and improving economic conditions for cities, regions, and groups left behind in the last decade.
Even in the eurozone, there is some movement. Germany will spend more on refugees, defence, security and infrastructure, while reducing taxes moderately. With the European commission showing more flexibility on targets and ceilings, the rest of the eurozone may also be able to use fiscal policy more effectively. If fully implemented, the so-called Juncker Plan, named after the commission’s president, Jean-Claude Juncker, will boost public investment throughout the European Union.
As for the US, there will be some stimulus regardless of whether Hillary Clinton or Donald Trump wins the presidential election. Both candidates favour more infrastructure spending, more military spending, looser limits on civilian spending and corporate tax reform. Trump also has a tax-reduction plan that would not be revenue-neutral and would expand the budget deficit - though the effect on demand would likely be small, given the concentration of benefits at the very top of the income distribution.
The fiscal stimulus that will result from these uncoordinated G7 policies will likely be very modest – at best, 0.5% of GDP of additional stimulus a year for a few years. This means that more stimulus, particularly spending on public infrastructure, will probably be warranted. The measures undertaken or contemplated so far already represent a step in the right direction.
•Nouriel Roubini is a professor at NYU’s Stern School of Business, and was senior economist for international affairs in the White House’s council of economic advisers during the Clinton era. He has also worked for the IMF, the Federal Reserve, and the World Bank.
Active v Passive Fiscal Policy
Generally, the economy doesn’t require additional intervention and the established laws on taxation and government spending remain in effect for extended periods. So, most of the time, taxation levels and government spending remain consistent or rise fairly steadily—they don’t change much from one budget to the next.
This steady pace helps maintain stability and consistency in the economy. People simply go about their business, earning income, buying goods and services, making decisions about saving and investing, and so on. So when the economy keeps moving at a healthy pace, fiscal policy changes generally aren’t necessary and fiscal policy is passive. Passive fiscal policy means the federal government allows existing policy to remain unchanged and leaves the laws as they are written.
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This steady pace helps maintain stability and consistency in the economy. People simply go about their business, earning income, buying goods and services, making decisions about saving and investing, and so on. So when the economy keeps moving at a healthy pace, fiscal policy changes generally aren’t necessary and fiscal policy is passive. Passive fiscal policy means the federal government allows existing policy to remain unchanged and leaves the laws as they are written.
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Reset fiscal policy after Brexit?
Chancellor of the Exchequer Philip Hammond said he’s ready to “reset” Britain’s fiscal policy if needed to respond to turbulence caused by the decision to vote to leave the European Union.
“In the short term, our colleagues at the Bank of England will be using the monetary tools at their disposal,” Hammond said in Beijing on Friday ahead of a meeting with fellow Group of 20 finance ministers in Chengdu, China. “Over the medium term, we will have the opportunity with our Autumn Statement, our regular late-year fiscal event, to reset fiscal policy if we deem it necessary to do so.”
Hammond’s comments came prior to publication of flash estimates of the impact of the Brexit vote on U.K. services and manufacturing, with the composite July Purchasing Managers’ Index falling to its lowest in seven years and shrinking at the fastest pace on record. The pound reversed a weekly gain, dropping 1 percent to $1.3102 at 12:35 p.m. London time.
Does fiscal policy solve unemployment?
Is the fiscal policy effective/the best policy to deal with unemployment?
It is an interesting question, and one that is likely to generate different views from within the ranks of Economists.
To give a very rough overview:
- Keynesians say yes, fiscal policy can be effective in reducing unemployment. In a recession, expansionary fiscal policy will increase AD, causing higher output, leading to the creation of more jobs.
- Classical Economics say no. Fiscal policy will only cause a temporary increase in real output. In the long run, expansionary fiscal policy just causes inflation and does not increase real GDP. Classical economists argue that to reduce unemployment it is necessary to use supply side policies which increase the flexibility of labour markets (e.g. reducing power of trades unions)
So who is Right?
In a way I find the distinction between Keynesian and Classical economists rather artificial. I believe that under certain circumstances both can be right.
Firstly, I do believe that fiscal policy CAN reduce cyclical unemployment. In a recession, cutting taxes and increasing government spending can increase AD, and this injection into the economy is likley to create jobs.
Note: fiscal policy has many limitations such as:
- crowding out (government borrowing reduces size of private sector)
- Tax cuts may be saved not spent
- Time Lags
- See: Criticism of fiscal policy for more details
However, despite these limitations it can play a role in increasing AD and reducing cyclical unemployment.
Can Fiscal Policy Solve Unemployment?
No, fiscal policy cannot solve supply side unemployment. If there is frictional or structural unemployment, fiscal policy will not solve this. For example, suppose some former miners are unemployed. The problem here is lack of skills and geographical immobilities. Therefore, what is needed is supply side policies. Increasing AD and economic growth does not solve the mismatch of skills. Therefore, when the economy is at full capacity Classical economists are correct. My criticism of the classical model is that in the long run the economy always reaches full output, this is not the case.
Does Fiscal Policy Cause Inflation.
If you increase AD, it could cause inflation. In a recession, when there is spare capacity inflation is unlikely to be a problem. However, if AD increases too much, when the economy is close to full capacity then it will cause inflation.
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Evaluation of fiscal policy
The impact of expansionary fiscal policy will depend on many factors:
- What else is happening in the economy? E.g. US tried to cut taxes in 2008. In theory, this lower tax should boost spending. However, the economy is experiencing falling house prices, lower confidence and a shortage of credit; because of all these factors expansionary fiscal policy is relatively ineffective.
Crowding Out
- Does crowding out occur? Expansionary fiscal policy involves higher spending and more government borrowing; it could cause crowding. This means that although the government spend more because they borrow from private sector, the private sector have less to spend and invest. Therefore, overall AD doesn’t increase.
Timing of Fiscal Policy
- A key issue of expansionary fiscal policy is the state of the economy. If expansionary fiscal policy is pursued when the economy is close to full capacity, then the increased government borrowing is likely to cause crowding out and / or contribute to higher inflation.
- However, in a liquidity trap, private saving rates rise rapidly. Therefore, expansionary fiscal policy helps to offset the rise in private sector saving and injects money into circular flow. In a deep recession, expansionary fiscal policy won’t cause crowding out or inflation.
Supply Side Effects
- Lower income tax may increase incentive to work
- Higher government spending on education and training, could increase long-term labour productivity. But, also government spending could be inefficient and wasteful – it depends what government spends on.
Expansionary fiscal policy
Expansionary fiscal policy involves government attempts to increase aggregate demand. It will involve higher government spending and / or lower tax. In theory, higher government spending will increase aggregate demand (AD=C+I+G+X-M) and lead to higher economic growth.
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Reducing unemployment
There are two main strategies for reducing unemployment –
- Demand side policies to reduce demand-deficient unemployment (unemployment caused by recession)
- Supply side policies to reduce structural unemployment / (the natural rate of unemployment)
Quick list of policies to reduce unemployment:
- Monetary policy – cutting interest rates to boost AD
- Fiscal policy – cutting taxes to boost AD
- Education and training to help reduce stuctural unemployment
- Geographical subsidies to help firms invest in depressed areas
- Lower minimum wage to reduce real wage unemployment
- More flexible labour markets, to make it easier to hire and fire workers.
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