Learning Objectives eepain what i meant Define fiscal policy. aaa Tent te acorns nen Sheaisoay jistinguish between prc 7 Loox 2 ear a tween progressive, regressive and proportionate taxation systems. Yescribe: alanced budgets multiplier. ” Trade Cycles ‘economic activ- ¢ trade or economic ‘A quite noticeable feature of virtually all economies is the cyclical navure of ity over time as it moves between booms and recessions. This is referred to as th business cycle as shown in Figure 29-1. When economic activity is expanding, growth is achieved and the actual rate of growth is positive. A decline in economic activity: on the other hand, implies that the actual growth rate is negative and this is termed an economic contraction’. A boom occurs when the level of ourput and employment in the cconomy is on the rise. This occurs berween a peak and a trough when the trade cycle is upward sloping. A recession is when the volume of ourput and employment in the economy eon the decline, This occurs between a peak and a trough when the trade cycle is down- ward sloping. Booms in the Economy cycle as shown in Figure 29-1. In this stage of the in the economy rise to very high levels. for the economic agents within the econ- ‘ome associated with a boom may encour- yy cause balance of ‘Aboom occurs at the peak of the trade trade cycle, the level of ourput and employment Overall, this enables a higher standard of living ‘omy. It must be noted that the higher level of inc: f imported goods and services and this may if the boom causes income to rise to the full employment ure would result in inflation. age greater consumption o} payments problems. Furthermore, level of ourpur, then any further increases in expendi 45329.3 29.4 ‘Maccoeconnmic Problems and Policy Figure 29-1 The Poetry Cameco g Eeonomic Notional income i Contraction 3 or Recession s ~~ economic Peak t Trough Time During a boom, it may therefore be necessary to curb spending in order to avoid infla. tion, The government can achieve this end by cutting expenditure on public sector projects such as roads, railways, hospitals, etc. and by increasing taxation, These steps would have a dampening effect on spending which is known as ‘deflationary policy’. Recession/Slumps in the Economy ‘A recession or slump is when the volume of output and employment in the economy has fallen resulting in a decrease in the level of income and depressed living standards. This is the bortom or trough of the trade cycle as shown in Figure 29-1. A slump therefore reduces total spending within the economy and this reduces inflationary pressure. In addition, a slump also has the effect of reduced spending on imports and this improves the current account of the balance of payments. Keynes argued that it was up to the government to create demand during a recession via reflationary policy through increased spending on public investment projects and a cut in taxes. Not only would this stimulate economic activity and create jobs for the unemployed, but ie would also improve the infrastructure of the economy. The Trade Cycle and the Need for Stabilization Policy A very convenient analogy to use in explaining the need for stabilization policy is to com- pare the economy to a hot air balloon. The amount of air in the balloon is representative of the level of economic activity. When the amount of hot air in the balloon decreases, it descends. Similarly, when the level of economic activity in the economy decreases, the level of income descends bringing about a recession. To send the balloon back into an ascent, more hot air has to be pumped inco it. In the case of the economy, to increase the level of income, the level of economic UNIT 2 1As more and might become ne hot air is added to the balloon, it would rise higher and higher or it as a and burst. This is similar to when the level of economic activity increase any further Ae ago meximmum at the potential level of income, where it cannot pressure. To solve the preg eceate CxPenditure continues 0 increase, it only causes inflationary are ea a oF the balloon being over inflated, the volume of hor air held in by the government woah non to circumvent rising prices policy measures are necded a aaa the level of aggregate expenditure. These measures are known as Coming b: , abe ming back to the analogy, if the capacity of the balloon is expanded, then it would be In applying th ‘odate a higher intake of air without becoming over inflated and exploding, ccomanny at ee the economy, policies are required to increase the capacity of the ae rctered a eiltate an increase in the level of agaregate expenditure. These policies ae supply-side policies’ and their impact is represented by a rightward shift of 'ggtegate supply curve and the full employment line in the Keynesian cross diagram. 29.5 Fiscal Policy Fiscal policy is the management of the economy through the level of government expendi- ture and taxation. That is, the government can use this demand management tool to achieve its macroeconomic objectives by manipulating the fiscal budget. Since it involves public spending and taxation, the arm of government which is in charge of this policy option is the Ministry of Finance. 29.6 Expansionary or Reflationary Fiscal Policy Governments may choose to use expansionary fiscal policy in times of recession when there isa general downturn in economic activity. Specifically, taxes would be lowered and govern- ment expenditure would be increased. This would lead to an upward shift of the aggregate expenditure curve as shown in Figure 29-2. ‘As shown in Figure 29-2, the initial equilibrium position occurs at point E,, where income is Y,. If the government implements expansionary fiscal policy, this has the effect of shifeing the aggregate expenditure curve upward from AE, to AE,. As a result, this brings about a new equilibrium at E, where the level of income has risen to Y, which increases the level of output and employment in the economy. 29.7 Deflationary or Contractionary Fiscal Policy Deflationary fiscal policy is likely to be most appropriate when an economy is growing above its capacity, resulting in inflation and balance of payments problems. To try to slow the economy down, the government could either raise axes in some form or perhaps reduce its expenditure. Fither of these will reduce the level of demand in the economy and there- fore the level of aggregate expenditure as shown in Figure 29-3. 455 UNIT 2Pe ae ee catanet Pye exes Ye If che government reduces its expenditure or increases taxation or both, this would shift the aggregate expenditure curve downwards from AE, to AE,, which would reduce the level of income from Y, to Y,. This is desirable since the decline in aggregate expenditure reduces inflationary pressure from the economy. 29.8 Macroeconomic Problems and Fiscal Policy Solution Given the distinction between expansionary and oti icy, i be ansionary and contractionary fiscal policy, it must noted that each would be applicable to certain macroeconomic targets. Table 29-1 identifies which fiscal policy solution is appropriate for each macroeconomic problem. ae ONT 2 Ma29.9 Discretionary Fiscal Poli i Stabilizers olicy versus Automatic 29.10 UNIT 2 the lel ofr fecal policy refers vo an active decision taken by the government to change stant, Deoseetment spending andor che lesl of tation (achieve a macroeconomic i ession when unemployment exists, the government can implement discretionary fiscal policy to increase aggregate expenditure by increasing government spending and reducing taxation. In times of inflation, the government can decide to reduce spending and increase taxation. Automatic stabilizers are mechanisms that lead to an automatic fiscal stimulus during a recession and an automatic fiscal dampening during a boom. In other words, an auto- matic stabilizer offsets the current economic climate without any active policy decision by the government. Unemployment benefits which are grants given by the government t0 the unemployed is an aucomatic stabilizer, as it automaticalh In addition, during a recession, income tax collected by the government falls and this also abates the recession in the economy. During a boom, if there is inflationary pressure in the economy arising from excess aggregate demand, then unemployment would be low and the government would auto- matically spend less on unemployment benefits. In addition, income tax collected by the government would auromatically rise, as there is more income to tax. This decrease in gov- ernment spending and the increase in taxation would also have a dampening effect on inflation. increases during a revesion. Potency of Fiscal Policy This section covers the factors which affects the potency or effectiveness of fiscal policy. 1. Crowding Out Effect—If the government implements expansionary fiscal policy by reducing taxation, or by increasing government spending, then this will lead co a budger deficit. To finance the deficit, the government will have to borrow which puts upward pressure on the race of interest as the government competes for limited funds with the private sector. As the rate of interest goes up, private investment and 457Macroeconomic Problems and Policy consumption are discouraged and this leads to a fall in aggregate expenditure. In other swords, the high level of government spending ‘crowds out’ private sector spending Overall, this counteracts the impact of expansionary fiscal policy on the economy making it less effective. 2. Excess Capacity—The effectiveness of fiscal policy in achieving an increase in the leve} of output produced in the economy also depends on whether or nor the economy pos. esses excess capacity. I full employment already exists in the economy, then expansion. aty fiscal policy would be absolutely ineffective in achieving an increase in output as the only result would be inflation. If, however, there is spare capacity in the economy, then the increase in aggregate demand stimulated by the fiscal expansion would be effective in achieving an increase in output without causing any inflationary pressure. 29.11 Main Types of Taxation 1. Direct taxes are taxes which are based on income or wealth and are paid directly to the taxation authorities of the government (Board of Inland Revenue). This includes the following: + Income taxes which refer to the portion of income earned by workers which are paid to the state. All income earners are given a tax-free personal allowance as well as other deductibles, All income above these allowances is subject to income taxes. + Corporation taxes account for the taxes levied on company profits. «+ Property taxes are paid based on ownership of property. All properties are valued and the amount of tax paid depends on the valuation. 2. Indirect taxes are taxes on expenditure. The tax is included in the selling price of goods and services and is paid by the consumer only if he or she actually buys the good or serv- ice in question. As such, the seller collects the tax and then passes it on to the taxation authorities. These taxes include: + Value added tax (VAT) or ad valorem tax which is based on the value of the good or service. In Trinidad and Tobago, the rate of VAT is 15 percent. This means that if a television set has a price of $1000, then 15 percent or $150 is added to this price. The VAT inclusive price the consumer pays is therefore $1150. * Specific taxes or duties are taxes applied to each unit of the good or service pur- chased by consumers. For example, the government can impose a specific tax of $10 on the sale of each bottle of wine consumers purchase, 29.12 Tax Burden ‘Taxes reduce the amount of goods and services consumers can afford with their income. This reduction of consumers’ purchasing power is referred to as the ‘tax burden’. Some taxes impose greater tax burdens on different income earners. 458 uNnit2 mac 20ECONOMICSIf the percentage ais rare ntage of income taken in tax ine . gressive. This would apply ines creases as income the income tax rate increases from 30 enn 3 A regressive tax is one where, as hone falls. An example of this is the airporr eo was $100 per person. This is eyreniee a rises, then the tax is pro- ome rises from $10,000 to $20,000, reent to 35 percent. the percentage of income paid in taxes x in ‘Trinidad which when it was in force, Tessive because if a person's income is $1000, the departure tax represents 10 percent of i of income whe represents only 5 percent of ine hereas if income rises to $2000, the departure tax If the tax is neither progressive no , then itis proportional. This would apply rence the percentage of income taken in tax stays the income rises. For instanc ae For instance, if the rate of income tax is fixed at 25 percent, then as ® 000 to $5000, a constant 25 percent is paid in taxes. 29.13 Indirect Taxes: Regressive or Progressive Most indirect taxes are regressive, Take, for instance, a hypothetical case where a specific tax of $0.50 per litre is imposed on gasoline. To illustrate this, assume that a higher income person who earns $100,000 per year and a lower income person who earns $40,000 per annum both drive to work and cover the same mileage. If both drivers consume 2000 litres of fuel per year, then they both pay $1000 in gasoline taxes. This represents a regressive tax, since the percentage which the lower income driver pays in fuel tax is 2.5 percent of income while the higher income driver pays only 1 percent of his income. 29.14 The Balanced Budget Multiplier Suppose the government wants to spend an additional $20 billion on infrastructural improvements but wants to raise the money by increasing taxes by the same amount; in such a case, the increase in government expenditure of $20 billion is exactly matched by an increase in autonomous taxation of $20 billion. In this situation, national income increases by the same magnitude, as the increase in government spending and taxation. That is, national income grows by $20 billion. This is known as the ‘balance budget multiplier’, which occurs whenever there are equal increases in both autonomous government spending and taxation. This scenario seems counter intuitive, as it would be expected that if both government spending and taxes increase, there would be no net injection into the economy and national income would be unchanged. ‘The $20 billion tax imposed on households increases withdrawals in the economy and hence lowers disposable income of households by this amount. If the MPC is 0.8, it means that only $16 billion is spent on consumer goods and services. Thus, the impact of the increase in taxes is a decrease in consumption of $16 billion. ‘Overall, the decrease in consumption of $16 billion and the increase in government spending of $20 billion results in a net injection of $4 billion into the circular flow of income. The MPC of 0.8 implies that the multiplier is 5 [1/(1-0.8)], which means that the net injection of $4 billion results in an increase in national income of $20 billion unit 2 4 Mics 453(64 billion 5). Conclusively, although the government has a balanced budget, there ig doirorner injection into the economy which results in an increase in the level of nationg, income. ” one i Concusively, since the increase in government expenditure of $20 billion coupled wich an increase in taxation by this equivalentamount leads to cpm reais! income by spevame magnitude, the balanced budget multiplier is therefore equal co 1, Key Terms _ a 1. Trade cycles 7. Potency of fiscal policy 2. Economic recession 8. Direct taxes 3. Fiscal policy 9. Indirect taxes 4, Reflationary fiscal policy 10, Regressive taxes 5, Deflationary fiscal policy 11. Progressive taxes 6. Balanced budget multipliers Review Questions 1. With reference to the trade cycle, why is sta~ 4, What is the balance budget multiplier? bilization policy necessary? 5. What factors influence the potency of fiscal 2. What is the difference between reflationary policy? fiscal policy and contractionary fiscal policy? 6. What is che difference between active fiscal 3. Can fiscal policy also affect the supply side of policy and passive fiscal policy? the economy? 7. What are automatic stabilizers? 1. The following questions are based on the information in the table, ‘Year GDP in Constant (2000) Prices in $M 2000 20,000 2001 22,000 2002 28,000 aes 26,000 oooe 23,000 ens 24,000 28,000 460 i unit 2 Macroaise c, plot a grap! t0 2006, Plot a graph showing the level of real GDP from 2000 b) Using the graph, identify th . Eee ¥ te years in which the following events along the trade i, Recession ii, Economic growth 2. State and expla three fiscal poli ; ree fiscal policy measures which can be used to achieve a decrease in unemployment, yy has a marginal propensity to consume (domestic goods ercent, explain the effects of the following on the level of ces) of 60 p income. a) The imposition of a tax of $104 of $1000 i i b) An increase in government spending of $10 million. ©) An increase in government spending of $10 million coupled with the imposition of a tax of $1000 per annum on all automobile on the road given that there are 10,000 automobiles registered. 4, Using a diagram, explain the effects of expansionary aggregate demand management policy when the economy is operating significantly below full employment. 5. Using a diagram, explain the effects of expansionary aggregate demand management policy when the economy is operating at full employment. 6. Inan economy, the MPC is 0.75. a) If the level of national income is currently $900 million and potential ourput is $1100 million, what would be the required increase in government spending to achieve full employment, assuming taxes remain unchanged? b) Use a Keynesian 45° diagram to show the effect on national income of the proposed action outlined in part a). ) If instead of holding taxes constant, the government decided to fund the increase in spending by an equivalent increase in taxation, whac would be: i. the required increase in government spending to achieve full employment? ii, the effect on the aggregate level of expenditure in the economy? iii, the name of the multiplier which applies in this scenario? 7. Demonstrate using diagrams, how fiscal policy could result in an increase or a decrease in output and employment. 461462 ‘and Paley Trecroeronomie Probie’ Answers Question 1 la {GOP in Constant (2000) Prices In Stn 90900-—— SYS 25,000 20,000 15.000 10,000 5,000 pooe-2008-«=« 200K 20052006 1b i) Recession from 2002 to 2004. 1bii) Economie growth from 2000 ro 2002 and 2004 ro 2006. Question 2 7m al measures to increase employment 1. Increased government spending on projects which create direct employment. The gov- ‘ernment can increase its expenditure on projects such structure which directly sremes employment opportunities. Such expenditure would also result in an increase in the productive capacity of the economy. Furthermore, given the multiplier effects, aggregate expenditure throughout the economy would expand as income rises. Such intremes in the demand for goods and services would also encourage entrepreneurs (0 produce greater output and more labour is employed. This means that the incre government spending also creates indirect employment. This type of measure would be suitable in reducing cyclical unemployment. Increased government spending on education. As the government spends more on edu- cation whether in terms of facilities or aid, the level of human capital in the economy would rise. This means the productivity of labour would be boosted and those who were previously unemployed would be able co obtain jobs. New industries would develop and a greater proportion of the labour force would be absorbed by employment opportunities. This type of fiscal measure would be applicable to solving structural and technological unemploym 3, Decreases taxation, Sometimes, if direct taxation is too high, it may be a major dis- couragement to economic activity. A reduction in taxation would enable workers to unit 2Mi CHAPTER 2S take home more di Both of these factors werk iteOM€ and compani poof aon woul pee eee to earn greater after-tax profits. al 7 tives to productive activities and encour- ci be a vey efi mean mE 2 wl ns cme wey Th omen ‘ll as firms to hire more workers. This unemployment, “@sure to reduce cyclical unemployment as well cfm) Question 3 0 result, national income would fed, Ul in a fll in aggregate expendicure. As a Eee all via the multiplier principle. In this, the multiplier is ee =06~04~>> The total increase in taxes would be $10 million, This would result in a decrease in atonal ncomety 665 $1000 per car times 10,000 cars. $25 million. 3b) Effect of an increase in government spending All other variables held constant, an increase in government spending which is an injection into the circular flow of income would result i i would result in an increase in aggregate expenditure. As such, production would expand and national income would tise via the multiplier principle. The end result is an increase in the equilibrium level of output. _ Given that government spending has increased by $10 million, with a multiplier of 2.5, national income would increase by $25 million. 3c) Effect of an increase in government spending and lump sum taxes An increase in government spending and taxation of equal magnitude while all other variables held constant would affect the level of national income via the balanced budget multiplier. This principle asserts that the equilibrium level of ourput would increase in equal magnitude to the increase in government spending. In this case, government spending increases by $10 million and taxes increase by $10 million. Due to the balanced budget multiplier, national income would increase by $10 million as this multiplier is equal to 1. Question 4 If the economy is operating significantly below full employment, then this means that high unemployment and excess industrial capacity exist. Faggregate demand increases through expansionary policies, then the result is an expansion in the level of ouput with the average price level remaining unchanged. This is shown in the figure by the increase in ourput of final goods and services from Y, to Yy- UNIT2 MA E f S ee464 Question 5 If che economy is operating at full employment, then there would be no unemployment or excess industrial capacity to produce more goods and services. If expansionary aggregate demand management policies are implemented, then the aggregate demand curve will shift to the right and che result would be a significant increase in the average price level with no increase in the output of final goods and services. fo AS Question 6 6a) An increase in the equilibrium level of output from $900M to $1100M MPC = 0.75 Required increase in Y = $200B = AY Multiplier = 1/1 — MPC) = 1/(1 ~ 0.75) = 4 Required increase in G = $50B UNIT 2 MACROECONOMICSUNIT 2 If government g income would rise by $200M from $ 6b) An increase in government spen, 6c i) When there is a simultaneou: As governments implement expansionary fi the aggregate expenditure curve as shown in the figure, Poi ere pending increases ai 8 Increases by $50 million, then given the multiplier of 4, national 900M to $1100M. ding by $50M 560 900 1100 Y s increase in both government spending and taxation, then increase in government spending needed to bring forth an increase in national income of $200B is $2008. 6c ii) As taxes increase, consumers have less disposable income and as a result, consumption decreases. The decrease in consumption would be determined by the MPC. Since the increase in taxes is $200B, then consumers would face a decrease in disposable income of $200B. If the MPC is 0.75, then consumption would decline by $150B. As govern- ment spending increases, the total level injections in the economy would rise. Since the increase in government spending is $200B, then the total level injections in the economy would rise by this amount. Overall, the decrease in consumers’ expenditure of $150B and the increase in injections of $200B would lead to an initial net increase in aggregate spending of $50B. Of course, this would now be subject to the multiplier of 4 which gives an overall increase in aggregate expenditure and national income of $200B. 6c iii) The balance budget multiplier of 1 applies. Question 7 Fiscal Policy Tools to Jncrease Output and Employment Expansionary or reflationary fiscal policy + Increase in government spending (G) * Reduction in taxation (T) al policy, this would lead to an upward shift of 465 ECONOMI‘Macroenonomie Problems and Policy Reflationary Fiscal Policy AE, AE, vo Wn v ‘As shown in the figure, the initial equilibrium position occurs at point E, where income ig Y,. If the government implements expansionary fiscal policy, this has the effect of shifting the aggregate expenditure curve upward from AE, to AE,. As a result, this brings abour new equilibrium at E,, where the level if income has risen co Y, which corresponds to the fall employment level of income. This means that there is an increase in both the level of output and employment in the economy. Fiscal Policy Tools to Decrease Ourput and Employment Deflationary or contractionary fiscal policy ‘+ Increase in taxation (T) * Reduction in government spending (G) ‘As governments implement deflationary fiscal policy, this will reduce the level of demand in the economy and therefore the level of aggregate expenditure falls as shown in the figure Contractionary Fiscal Policy ” Ae Yoae AE, Ag, ° ¥ Ye Yi If the government reduces its expenditure or increases taxation or both, this would shife the wnwards from AE, to AE, which reduces the level of income income implies that both output and employment have fallen. UNIT 2 MACROECONOMICS