EC131 Economics for Business - Macroeconomy

EC131 Economics for Business Steering the macroeconomy Fiscal policy What is the role of the government in promoting macroeconomic stability? What are the types of fiscal policy? What is discretionary fiscal policy and what are the challenges that come with it? EC131 Economics fo...

EC131 Economics for Business Steering the macroeconomy Fiscal policy What is the role of the government in promoting macroeconomic stability? What are the types of fiscal policy? What is discretionary fiscal policy and what are the challenges that come with it? EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  What is the role of the government in promoting macroeconomic stability? What are the types of fiscal policy? What is discretionary fiscal policy and what are the challenges that come with it? EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) The business cycle GD Full capacity P output Actual output Trend output 3 4 2 1 Time EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) The role of government What is the role of the government, given the business cycle? The government reduces the conflict between macroeconomic issues and creates macroeconomic stability Consider demand-side and supply-side policies Demand-side policies affect the aggregate demand and are usually short term (e.g. fiscal and monetary policies) Supply-side policies affect the aggregate supply and are usually long term (e.g. increasing productive capacity) EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  Example: Demand-side policy v. supply-side policy Price level AS Price level AS AS ’ Pe Pe AD’ AD AD Ye National output Ye National output EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  Example: Expansionary v. contractionary demand-side policy Price level AS Price level AS Pe Pe AD’ AD AD AD’’ Ye National output Ye National output EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  AS’ Interaction between ’ e AS demand-pull inflation d ’ P f and cost-push inflation AS c Addressing unemployment may create inflationary pressure as in point e b At this point (point e) there may be a “too much” inflation and lowering Pe inflation becomes relatively more important than lowering unemployment AD’ Deflationary measures such as ’ AD’ shifting the aggregate demand curve to the left from AD’’ to AD’ ends at a AD lower price level but at the expense of lower output (point f) At point f the government has to Ye Y accept higher unemployment in order to bring inflation down EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  Fiscal policy is mainly a demand management policy It manages the balance between government expenditure and taxation in order to Fiscal Prevent a severe recession (e.g. stimulus package during 2008/9 and 2020/21) policy Smooth out the fluctuations in the economy associated with the business cycle (e.g. reducing G and raising T during boom to prevent “overheating of the economy”, raising G and reducing T during economic slow down to boost economic growth and prevent a rise in unemployment) EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  Public sector consists of central government, local government, public corporations If G>T, the deficit can be financed through borrowing known as public sector net borrowing (PSNB) Fiscal The principal way of borrowing to finance a deficit (G>T) is through the sale of government policy bonds, sometimes known as gilt-edged securities or “gilts” Deficit is a flow concept, debt is a stock PSNB is the headline measure of deficit PSND is the key measure of the country’s overall debt EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) Public-sector net borrowing and public-sector net debt (per cent of GDP) I made these figures using data from Public Finances Databank of the Office for Budget Responsibility at https://obr.uk/data/. EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  We consider two types of fiscal policy Automatic fiscal stabilisers (e.g. progressive tax system may mean higher taxes or lower Fiscal benefits when income is high at the peak of the business cycle) policy Discretionary policy involves active government intervention, as automatic stabilisers may not be enough as a fiscal tool if there is a disequilibrium in the economy or substantial fluctuations in GDP EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) Discretionary fiscal policy Government budget: G + Ig = T + PSBR G is current public spending (e.g. day-to-day running of the economy) Ig is capital public spending (e.g. construction of schools or hospitals) T is government tax revenue PSBR is public sector borrowing requirement Sometimes tax revenue may be insufficient to cover government expenditures During recession the government may inject a lot of money into the economy For example during the health pandemic the government spends a lot on health services, vaccine development, furlough and job retention scheme, etc. The gap between government spending and taxation may be financed by borrowing (i.e. G + Ig – T = PSBR) During periods of economic boom government spending tends to be lower and tax revenue higher resulting in surplus, which in turn may offset future deficits EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) Discretionary How could governments intervene in a recession? fiscal policy How would the intervention be effective in promoting economic growth? EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  P Government spending AS AD = C + I + G + X – M An increase in government Pe spending G shifts the ’ aggregate demand to the Pe right, from AD to AD’ This increases output from Ye to Ye’ and unemployment decreases AD’ AD If the economy is coming from a low price level then the increase in price Pe to Pe’ may Ye Ye’ Y not cause much problem EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  P Taxation AS AD = C + I + G + X – M Suppose the government decreases tax on consumer Pe income ’ This will increase the aggregate Pe demand via disposable income and consumption C The aggregate demand shifts to the right, from AD to AD’ and AD’ output increases from Ye to Ye’ AD and unemployment decreases If the economy is coming from a low price level then the increase Y in price Pe to Pe’ may not cause Ye Ye’ much problem EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) Challenges with discretionary fiscal policy Pure fiscal policy (i.e. financed by borrowing money as opposed to increasing the money supply) could “crowd out” private borrowing and investment Borrowing from private individuals and firms could increase interest rate, which in turn may discourage private individuals and firms from buying on credit A cut in tax may be viewed as temporary or permanent Only a permanent cut in tax could lead to higher consumption The multiplier and accelerator depend on confidence Higher confidence could lead to larger multiplier and accelerator effects The risk of undermining the fiscal policy of the government may be higher because of increased interdependence between countries owing to globalisation EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) Timing matters: Is the fiscal policy stabilising GD or destabilising? P Consider the following business cycles The solid blue line is the path without intervention Ideally, the economy should be 3 dampened in stage 2, stimulated in stage 4 4 The black dashed line is the path with intervention that stabilises the 2 economy This flattens out the business cycle The government takes into 1 account the multiplier, accelerator, uncertainty, random shocks, etc. Time EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) Timing matters: Is the fiscal policy stabilising GD or destabilising? P Consider three types of business cycles The solid blue line is the path without intervention What if there was a time lag? 3 Deflationary measures in stage 2 occurred in stage 4, expansionary policies in stage 4 occurred in stage 2 4 The red dashed line is the path with intervention that destabilises the 2 economy Over-stimulating the economy creates inflationary pressure Under-stimulating the economy 1 plummets into a deep recession Accurate information and forecast also matter in aiding discretionary fiscal policy Time EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz)  Passive rather than active form of fiscal policy Fiscal rules For instance: Set the PSNB Government expenditure/taxes are adjusted to meet the PSNB target EC131 Economics for Business AY 2024-25 (Lecturer: Dr Jose Rowell Corpuz) Fiscal rules in the UK Labour government (1997-2010) Borrow only to invest (in roads, hospitals, schools); maintain a PSND of