Macroeconomic Policy: Lecture Outline

1. Objectives of macro policy 2. Fluctuations in business activity- historical record- causes of business fluctuations

3. Fiscal policy- policy instruments- financing a deficit- problems with fiscal activism- decline of fiscal activism

4. Sustainability of government debt

MACROECONOMIC POLICY

Objectives of macro policy:

• full employment

• stable prices

• steady growth

• equitable distribution of income

• balance of payments equilibrium (medium term)

Main focus of macro policy

• low inflation

• steady growth

• avoidance of recession

How can these objectives be achieved?

Policy instruments

1. Fiscal policy• govt spending (health, education, etc)

• taxation (income, expenditure, excise duties)

• income transfers (pensions, welfare)

2. Monetary policy• interest rates

• money supply

3. Exchange rate policy• fixed v floating

FLUCTUATIONS IN BUSINESS ACTIVITY

Historical record• recessions can be very severe

• all countries experience booms /slumps

• recessions are usually shorter than expansions

• business cycles are highly synchronised between ‘partners’ - inter-country linkages

• business cycles are less severe than in past - govt spending is stable - automatic stabilisers have ‘worked’ - active monetary policies (Greenspan after Asian crash)

Causes of business fluctuations• unexpected ‘shocks’ - wars, oil-prices, financial crises

• shifts in AD - investment is volatile (unpredictable behaviour) - price stickiness causes changes in ‘real’ variables

• technology shifts - new products / new processes

• govt-induced shocks - poor management of fiscal / monetary policy - time lags

What is fiscal policy? - govt’s attempt to control AD via G and T

Discretionary action

• change in government spending e.g. building new hospitals, roads, schools

• change in taxation e.g. tax rate, wealth tax, excise duty rates

FISCAL POLICY

Automatic stabilisers

- ‘kick in’ when economy moves into recession

- government spending increases e.g. welfare payments, unemployment benefit

- tax revenue falls in recessions (to maintain C) e.g. income tax

Fiscal policy stance

Financing government spending:

G - T = borrowing + creation of high-powered money

G > T = deficitT > G = surplus

- surpluses occur in booms; deficits in slumps

- budget deficit does not necessarily mean that fiscal stance is expansionary; recessions cause deficits

Controlling aggregate demand

• fiscal activism - fine-tuning of AD to achieve full employment - fine-tuning to reduce amplitude of business fluctuations

• fiscal balance has replaced fiscal activism - fine-tuning via fiscal policy has failed. Why? - monetary policy has replaced fiscal policy to ‘fine-tune’ the economy. Has this been a success?

Problems with fiscal activism

- fiscal activism involves discretionary action - govt has to decide how much stimulus is needed - need to know effect of fiscal injections (macro models used to predict effects) - governments tend to increase G/Y ratio

- budget deficits can easily get out of hand

Government spending / gdp

%1960 1970 1990 2000

EU 32 37 48 44Japan 17 19 32 32USA 27 32 37 33

Germany 33 39 45 44UK 32 34 53 44France 35 39 51 48Italy 30 34 53 44

Reasons for the decline of fiscal activism

• difficult to predict effects - inadequate knowledge of how economy works

- macro models are inadequate

- poor data

- long time lags in policy effects

- poor timing of policy changes

• political interference results in wrong policy action

- political cycles

- systematic bias towards deficits (popularity of low taxes)

• fiscal activism results in increasing debt - debt/gdp ratio increases (debt has to financed)

Debt / gdp ratios

%1990 2000

EU 41 69Japan 10 113USA 32 60

Germany 42 64France 40 64UK 39 50Italy 104 113

Reducing debt may have expansionary effects

• cut in G can lead to: - lower interest rates - more confidence in govt’s macro policy - inflow of private FDI

• greater consumer / investor confidence

• fiscal activism is useless due to ‘crowding out’

- ‘crowding out’ of private I via high interest rates

- households reduce spending due to expectation of higher taxes in future

But:

- households may not make link between budget deficit and future taxes

- households may not care about the distant future

- not much evidence to support negative impact of ‘crowding out’

Sustainability of debt: govts worry about debt/gdp:

• many developing countries get into trouble (Mexico) - desire for growth

• non-taxpayers / taxpayers increasing due to ‘demographic time bomb’ e.g. % 65+ 2000 2050

USA 12 21 Japan 17 30 EU 16 28

• need to keep interest rates below gdp growth rate to get debt / gdp down (or to run a deficit while keeping debt / gdp constant)

Conclusions

• fiscal policy has become more conservative

• debt burden too big; need for surpluses to repay debt

• inflationary consequences of expansionary policies

• financial markets ‘nervous’ of increases in govt debt (Can the govt meet its debt repayments?)

• pressure to reduce size of public sector - efficiency gains from privatisation - lower interest rates

• automatic stabilisers essential for macro stability

• fine-tuning replaced by coarse-tuning

- discretionary fiscal policy still has a role to play

- co-ordinated macro-policy between G7 (G3?) needed to keep world economy stable (due to high rate of transmission of economic shocks)