Macroeconomic management and fiscal policy

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Thorvaldur Gylfason IMF Institute/Center for Excellence in Finance, Slovenia Course on Macroeconomic Management and Financial Sector Issues Ljubljana, Slovenia September 21–29, 2011

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Objectives and uses of fiscal policy Stabilization, allocation, distribution Global financial crisis and fiscal policy response Benefits and risks related to fiscal policy Public debt dynamics Sustainability of public debt Safeguarding fiscal sustainability Exit strategies when things go wrong Fiscal reforms

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The term fiscal policy refers to the use of public finance instruments to influence the working of the economic system to maximize economic welfare Effects of fiscal policy reflect not only the impact of the fiscal balance, but also various elements of taxation, spending, and budget financing Assessing the stance of fiscal policy requires taking account of the activities of all levels of government

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Stabilization Fiscal policy influences aggregate demand Directly because Y = C + I + G + X – Z Indirectly because C depends on income after tax Through demand, fiscal policy affects output, employment, inflation, balance of payments Allocation Fiscal policy also influences aggregate supply Public infrastructure, education, health care Distribution Through taxes, transfers, and expenditures Progressive, neutral, regressive

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Fiscal policy can be used to several ends To achieve internal balance By adjusting aggregate demand to available supply By achieving low inflation, potential output To promote external balance By ensuring sustainable current account balance By reducing risk of external crisis To promote economic growth E.g., through more and better education and health care Fiscal policy needs to be coordinated with monetary, exchange rate, and structural – i.e., supply-side – policies

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Demand management E.g., lower income taxesAggregate supply in short runAggregate demandPrice levelOutputAB

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Demand management E.g., lower income taxesSupply management E.g., lower import tariffsAggregate supply in short runAggregate supply in short runAggregate demandAggregate demandPrice levelPrice levelOutputOutputABBA

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National income accounts Y = C + I + G + X – Z S = Y – T – C = I + G – T + X – Z, so G – T = S – I + Z – X Government budget deficit must be financed either by (a) having private saving in excess of private investment or (b) by accumulating foreign debt through a deficit in the current account of the balance of payments, or both Alternative formulation G – T = B + DG + DF Government budget deficit must be financed by borrowing either at home or abroad, i.e., from (a) the public, (b) the banking system, or (c) foreigners

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Central bank financing involves money creation Inflation tax: Most inflationary form of financing Bond finance is less inflationary Removes financial resources from circulation Increases real interest rates Crowds out private investment External financing can be inflationary Especially if it leads to currency depreciation Evidence from cross-country data Strong links between budget deficits and inflation in developing countries, but not in industrial countries Bond finance is the rule in industrial countries … … and money finance is the exception

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Conventional budget surplus T – G Large in upswings when tax base (Y) is strong Small in downswings when tax base is weak Full-employment surplus TFE – G Use tax revenue as it would be at full employment Independent of business cycles A budget in deficit could be in surplus with full employment Deficit can be consistent with a tight fiscal stance (see chart)T, GYYFEY < YFETG

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Public sector borrowing requirement Broad measure of public sector deficit, including central, state, and local government Primary budget balance Leaves out interest payments Conventional deficit = G – T = GN + GI – T = GN + iDG - T Primary deficit = GN – T = G – T – iDG

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Operational deficit Leaves out inflation component of interest payments Operational deficit = conventional deficit minus inflation component of interest payments = primary deficit plus real component of interest payments Conventional deficit: G – T = GN + iDG – T = GN + (r + p)DG – T Operational deficit: G – T - pDG = GN – T + rDG Hence, operational deficit includes only real part of interest payments, leaves out the inflation part

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Before Great Depression 1929-39, many thought that governments needed to balance their budgets from year to year Even so, US had built is railways through borrowing, for example Keynes revolted (General Theory 1936) If private sector failed to consume and invest, government could fill the gap Y = C + I + G + X – Z C and I and G appear side by side Guns or butter? Makes no difference Also, could reduce taxes to encourage C and I

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Multiplier analysis It could be shown that, with unemployed resources, an increase in G would raise Y by an amount greater than the original increase in G Active fiscal policy was used consciously in Sweden even before Keynes … … and adopted in US and elsewhere after 1960 (Kennedy-Johnson administration) Coincided with buildup of US as a welfare state with greater emphasis on public services and social security, like in Europe Active fiscal policy came naturally to Europe

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Fiscal policy can affect Aggregate demand, output, and price level Cut taxes: Consumption, output, and prices rise Rate of monetary expansion and inflation Increase spending financed by credit expansion: Money expands (M = D + R), so inflation goes up Aggregate supply and economic growth Boost infrastructure, education, and health care: Efficiency and long-run growth go up Current account of balance of payments Raise taxes: Disposable income and imports fall, so current account improves unless currency appreciates

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Fiscal multipliers are positive, but small Impact of fiscal policy actions depends on Whether economy is open or closed (import leakage) Exchange rate regime (fixed or floating) Type of budget financing (money creation or debt) Degree of confidence in economic policy Level of government debt outstanding Financing constraints Risk premia on debt Whether fiscal changes are considered temporary or permanent How close the economy is to full employment

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(+)(+)(+)(-)(-)(+)(-)RE (+)(+)(+)(+)(+)(-)(-)

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Monetary survey M = R + D D = DG + DP Fiscal policy determines government’s demand for bank financing (DG), which, in turn, affects total domestic credit (D), i.e., net domestic assets (ignoring other items net), and money (M) Increased budget financing requires greater monetary expansion unless credit to private sector (DP) is cut or foreign reserves (R) go down, reflecting a weaker balance of payments position

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In times of financial and economic crisis, fiscal policy plays key role in government’s response Fiscal policy played a role during Great Depression, even if theory behind it was poorly understood, or even disputed Fiscal policy plays key role in current crisis Monetary policy is ineffective if real interest rates cannot be reduced without igniting inflation Fiscal policy is more effective Massive fiscal stimulus in US, Europe, and Asia: it works! Fiscal stimulus is assisted by automatic stabilizers

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Need for financing tends to lift interest rates, so capital flows in and currency tends to appreciate Central Bank must offset incipient appreciation by expanding money supply, thereby reinforcing initial fiscal stimulus Otherwise, exchange rate could not remain fixed

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Need for financing tends to lift interest rates, so capital flows in and currency appreciates Appreciation reduces net exports, aggregate demand, and interest rates Process continues until interest rates fall to their initial level So, fiscal stimulus is ineffective with perfect capital mobility

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In times of large deficits and growing public debt, public spending can have weak or even negative effects By creating expectations of a fiscal crisis, and hence of higher future taxes Increased saving may lead to a sharp fall in consumption Hence, fiscal stimulus can fail, and may even prove counterproductive Conversely, fiscal contraction may prove expansionary

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Fiscal policy is frequently key to addressing balance of payments problems Simple mechanism M = R + D means DR = DM – DD = DM – DDG – DDP Hence, given DM and DDP, key to raising DR is reducing DDG IMF: It’s Mostly Fiscal!

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Or look at it this way: Y = C + I + G + X – Z means X – Z = Y – C – T – I – G + T = S – I + T - G Hence, current account balance (X – Z) equals sum of private sector surplus of saving over investment (S – I) and government surplus of taxes over public expenditure (T – G) Equivalently, Z – X = I – S + G – T means that external deficit equals sum of private sector deficit and government budget deficit

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Unsustainable fiscal policy can trigger a crisis if public loses confidence in government’s macroeconomic policy Sudden capital outflow can result, weakening the balance of payments and leading to a sharp devaluation Financing the budget externally builds up external debt, increasing risk of crisis Fiscal sustainability thus matters not only for debt, but also for balance of payments

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Fiscal contraction (spending cuts, tax increases) can slow down inflation, reduce current account deficit Fiscal expansion (tax cuts, spending increases) can shrink unemployment, increase aggregate demand and help restore output to full capacity, i.e., bring actual GDP up to potential GDP, especially if monetary policy is impotent

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Last Updated: 8th March 2018

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