Fiscal Policy Exam PDF

Week 1 Definition of Fiscal Policy Fiscal policy refers to how the government spends money and collects taxes to influence the economy. The goal is to maximize economic welfare by maintaining stable growth, reducing unemployment, and control...

Week 1 Definition of Fiscal Policy Fiscal policy refers to how the government spends money and collects taxes to influence the economy. The goal is to maximize economic welfare by maintaining stable growth, reducing unemployment, and controlling inflation. Key aspects of fiscal policy: Impacts government budget  Can lead to a surplus (extra money ) or a deficit (spending more than collected ). Involves taxation, spending, and borrowing as tools. All levels of government (national, regional, local ) play a role in fiscal policy. Tools of Fiscal Policy Two main tools of fiscal policy: Government Expenditure Spending)  Funds infrastructure , education , healthcare , defense. Taxes  Government collects money from people & businesses. Fiscal policy can be: Expansionary (boost economy): Increase spending (e.g., building roads , unemployment benefits ). Reduce taxes (so people have more money to spend ). Contractionary (slow economy & reduce inflation): Decrease spending (cut budgets ). Increase taxes (reduce peopleʼs extra cash ). Taxes as a Tool Taxes are the governmentʼs main way of collecting money to fund public services. Goals of taxation: Week 1 1  Control demand in the economy. Raise revenue to finance government programs. Redistribute wealth (progressive taxes make the rich pay more ). Correct market failures (e.g., high taxes on cigarettes to reduce smoking). Types of Taxes: Income Tax  Taken from salaries. Sales Tax  Added to purchases VAT, GST. Corporate Tax  Paid by businesses on their profits. Excise Tax  Applied to specific goods (alcohol, tobacco, fuel ). Custom Duties  Taxes on imports & exports. Types of Taxes Direct Taxes  Paid directly by individuals or businesses Income tax, Capital Gains tax, Corporate tax). Indirect Taxes  Passed on to consumers in the form of higher prices Sales tax, VAT, Customs duty). Other Taxes  Additional taxes used for specific purposes Property tax , Toll tax , Stamp duty, Environmental taxes ). Simple Explanation of Key Concepts Fiscal Deficit  When the government spends more than it earns (it needs to borrow money ). Surplus Budget  When the government earns more than it spends (rare, but happens ). Balanced Budget  Government spending exactly equals tax revenue (theoretical ideal ). Government Expenditure To grow the economy, the government must spend money on projects that matter. Week 1 2  Three main areas of government spending: Transfer Payments  Welfare payments not in exchange for goods or services (e.g., pensions, unemployment benefits, social security). Current Spending  Government spending on daily operations like salaries for teachers and nurses. Capital Spending  Long-term investment in infrastructure such as roads , hospitals , and prisons. Government Expenditure Tools The government uses three main ways to finance its spending: Taxation  Collecting money from the public to fund projects. Natural Resources  Revenues from oil, gas, and other natural resources. Deficit Financing  When spending exceeds revenue, the government borrows money (through bonds or printing new money ). Government Expenditure vs. Taxes Government purchases have a direct impact on aggregate demand. Example: If the government builds new highways , it immediately boosts demand for workers, materials, and services. Taxes have an indirect impact on aggregate demand. Example: A tax cut gives people more disposable income, leading to higher consumer spending , which eventually boosts demand. Key Takeaways Recap Week 1 3  Objectives of Fiscal Policy Stabilization Fiscal policy influences aggregate demand, which affects overall economic activity. Directly through the equation: Y  C  I  G  X  m Where: Y  National income GDP C  Consumption (household spending) I  Investment (business spending on capital goods) G  Government spending (public services, infrastructure) X  Exports (goods sold abroad) M  Imports (goods bought from abroad) Indirectly, because consumption (C) depends on income after tax. Fiscal policy impacts key economic indicators like output, employment, inflation, and balance of payments through its effect on demand. Allocation Fiscal policy also influences aggregate supply by directing resources to key sectors. Week 1 4  The government allocates spending on public infrastructure, education, and healthcare, which improves economic productivity in the long run. Distribution Fiscal policy helps redistribute income through taxes, transfers, and expenditures. There are three types of tax systems: Progressive  Higher-income individuals pay a larger share (e.g., income tax). Neutral  Tax burden is the same proportionally. Regressive  Lower-income individuals pay a higher share relative to income (e.g., sales tax). Key Takeaways Recap Stabilization: Fiscal Policy & Economic Balance Internal Balance An economy is in internal balance when it achieves: Full employment  No excessive unemployment or inflation. Stable prices  Inflation is controlled. To maintain internal balance, fiscal policy can: Adjust aggregate demand to match supply (reduce excess demand or stimulate weak demand). Control inflation and keep output at its potential level. External Balance Week 1 5  An economy is in external balance when: The balance of payments (current + capital account) is sustainable. Foreign trade and capital flows do not create excessive deficits or surpluses. To promote external balance, fiscal policy can: Ensure a sustainable current account balance (exports ≈ imports). Reduce risks of external crises, such as currency devaluation or excessive foreign debt. Graph: Demand Management & Internal Balance Lowering income taxes increases disposable income, shifting aggregate demand to the right. As demand increases, output rises, but prices may also increase (inflation risk). The new equilibrium moves from Point A to Point B, where aggregate supply meets higher demand. Key takeaway: Fiscal policy can stimulate growth but must be carefully managed to prevent excessive inflation. Comparison: Demand vs. Supply Management Demand Management Fiscal Policy) Uses tools like tax cuts or increased spending to boost demand. Leads to higher output and prices (inflation risk). Supply Management International Policy) Uses tools like reducing import tariffs to increase aggregate supply. Leads to lower prices and higher output (more supply means lower costs). Key takeaway: Demand-side policies work in the short term but can cause inflation. Supply-side policies increase long-term productivity without inflationary pressure. Week 1 6  Fiscal Policy & External Balance The national income equation: Where: Y  GDP C  Consumption I  Investment G  Government Spending X  Exports M  Imports Other Equations: Savings-Investment Balance: → Private saving excess  Gov. deficit  Trade surplus Government Budget Deficit Must Be Financed By: (a) Excess private savings (if S  I, private sector funds the deficit). (b) Foreign debt (if X  M, country borrows to cover trade deficit). Key takeaway: A government can finance a deficit internally (higher savings) or externally (borrowing from abroad). Key Takeaways Recap Week 1 7  Fiscal Policy and External Balance National Income Accounts The economyʼs income can be broken down as: Y  CIGXM Where: Y  GDP (total income of the economy) C  Consumption (household spending) I  Investment (business spending) G  Government spending X  Exports (goods/services sold abroad) M  Imports (goods/services bought from abroad) Another way to express this: S  I  GTXM This means: S  I  Private sector saving minus investment G  T  Government deficit/surplus X  M  Trade balance (net exports) If the government runs a deficit G  T, it must finance it either by: Excess private savings S  I Foreign borrowing X  M Fiscal Policy and Balance of Payments Rewriting the equation: X  M  SITG Week 1 8  This means that the current account balance (exports - imports) is influenced by: Private sector surplus S  I Government fiscal balance T  G If the government spends more than it collects in taxes, it may create a twin deficit: Budget Deficit G  T Trade Deficit M  X Key takeaway: If a country imports more than it exports and has a budget deficit, it will need to borrow from abroad, increasing foreign debt. Unsustainable Fiscal Policy & Economic Crises When the government keeps running deficits, it can lead to serious problems: Loss of investor confidence  Capital outflows and currency depreciation. Excessive borrowing  Increased foreign debt, making future crises more likely. Macroeconomic instability  Inflation, recession, and financial crises. Key takeaway: A country must ensure fiscal sustainability to avoid economic instability and balance of payments crises. Key Takeaways Recap Week 1 9  Fiscal Policy and Balance of Payments Current Account Balance & Government Deficit X  M  SITG This equation shows that the trade balance (exports - imports) is linked to: Private sector savings-investment balance S  I Government fiscal balance T  G If S  I (more savings than investments), the private sector has extra funds. If T  G (more taxes than government spending), the government has a budget surplus. A positive current account balance X  M  0 means the country exports more than it imports (trade surplus). Alternatively, rewriting the equation: M X  ISGT A trade deficit M  X means the country imports more than it exports. This can happen when the private sector invests more than it saves or when the government runs a budget deficit. Key takeaway: A country with a budget deficit G  T and low savings S  I will borrow from abroad to finance its deficit. The Risk of Unsustainable Fiscal Policy When a government keeps running large deficits, it can lead to: Capital outflows  Investors lose confidence, moving money out of the country, causing currency depreciation. Debt accumulation  Borrowing from abroad leads to high foreign debt, increasing crisis risks. Macroeconomic instability  If investors stop lending, the government may have to cut spending drastically, triggering a recession. Key takeaway: A sustainable fiscal policy is necessary to avoid economic crises, inflation, and a weakening balance of payments. Week 1 10  How Governments Finance Deficits Governments finance budget deficits G  T  0 through borrowing: Where: ΔB  Issuing government bonds ΔDᵍ  Borrowing from the central bank ΔDᴾ  Borrowing from the private sector (banks, investors) ΔDᶠ  Borrowing from foreign lenders Options for financing deficits: Issuing Bonds  Selling government bonds to investors (domestic or foreign). Borrowing from the Central Bank  Printing more money (inflation risk). Borrowing from the Private Sector  Taking loans from domestic banks. Foreign Borrowing  Taking loans from other countries or institutions IMF, World Bank). Key takeaway: The choice of deficit financing affects inflation, interest rates, and financial stability. Key Takeaways Recap Week 1 11  Inflationary vs. Non-Inflationary Finance Central Bank Financing (Inflationary) Involves money creation to cover government deficits. Leads to high inflation because more money is in circulation. Known as an "inflation tax", as it reduces purchasing power. Key takeaway: Printing money is the most inflationary way to finance a deficit. Bond Financing (Less Inflationary) Government sells bonds to investors instead of printing money. Effects: Reduces financial resources in circulation (absorbs excess liquidity). Increases real interest rates, making borrowing more expensive. Crowds out private investment, as higher interest rates discourage businesses from borrowing. Key takeaway: Bond financing avoids inflation but can slow economic growth by raising borrowing costs. External Financing (Risk of Inflation) Borrowing from foreign lenders can also lead to inflation. Week 1 12  Especially problematic if it causes currency depreciation, making imports more expensive. Key takeaway: External borrowing can fuel inflation if it weakens the exchange rate. Cross-Country Evidence In developing countries, budget deficits and inflation are strongly linked. In industrial countries, deficits are mostly financed through bonds, not money printing. Bond financing is the norm in advanced economies, while money creation is rare. Key takeaway: Developing economies are more vulnerable to inflation from deficit financing. Key Takeaways Recap Week 1 13  Week 2 France divided in 2 directions: justice reality Uses of Fiscal Policy Pre-Great Depression: Balanced Budgets Before 19291939, the dominant belief was that governments should balance their budgets annually. However, large projects (e.g., U.S. railways) were already financed through borrowing. Keynesian Revolution (1936) John Maynard Keynes General Theory, 1936 challenged the idea of always balancing budgets. His main argument: If private sector consumption and investment C  I fall, the government must step in. The government can increase G (spending) or cut T (taxes) to boost demand. "Guns or Butter" Debate  The government can prioritize military (guns) or social welfare (butter), but spending itself matters more than the category. Key takeaway: Keynes argued governments should actively use fiscal policy to smooth economic cycles. Government Spending During Crises The graph shows the share of federal government spending over time: Great Depression 1930s): Large increases in spending to combat economic collapse. Week 2 1  World War II 1940s): Government spending skyrocketed to finance the war effort. Post-war period 1950s–2014 Spending remained high but stabilized. Before the Great Depression, most spending happened at the state/local level. Since then, the federal government has taken a larger role, now accounting for two-thirds to three-quarters of all government spending. Key takeaway: Modern economies rely on active fiscal policy, especially in times of crisis. Key Takeaways Recap Expansionary vs. Contractionary Fiscal Policy Expansionary Fiscal Policy Used when GDP is below potential GDP (economic downturn, high unemployment). The government increases spending G or cuts taxes T to boost demand. This shifts Aggregate Demand AD to the right, increasing output and reducing unemployment. However, it may increase inflation (higher prices). Key takeaway: Expansionary fiscal policy stimulates growth but risks inflation. Week 2 2  Contractionary Fiscal Policy Used when GDP is above potential GDP (overheating economy, high inflation). The government reduces spending G or raises taxes T to slow demand. This shifts Aggregate Demand AD to the left, lowering inflation but slowing growth. Key takeaway: Contractionary fiscal policy controls inflation but can slow economic activity. Dynamic Aggregate Demand & Aggregate Supply Model Traditional fiscal policy models assume static GDP and prices. In reality, economies evolve dynamically, with long-run GDP growth and shifting price levels. Key takeaway: Using dynamic models improves fiscal policy decisions by considering long-term changes in growth and inflation. Expansionary Fiscal Policy in the Dynamic Model The economy starts in long-run equilibrium. The government expects aggregate demand to be too low for full employment. Policy response: Increase spending or cut taxes. Result: AD shifts right, raising GDP but also increasing price levels. Key takeaway: Expansionary fiscal policy raises employment but also inflation. Contractionary Fiscal Policy in the Dynamic Model The economy starts in long-run equilibrium. The government expects aggregate demand to be too high, causing inflation. Policy response: Cut spending or raise taxes. Result: AD shifts left, reducing inflation but also lowering GDP. Week 2 3  Key takeaway: Contractionary fiscal policy lowers inflation but slows growth. Key Takeaways Recap Fiscal Policy Results Effective Fiscal Policy Expansionary fiscal policy boosts GDP, inflates prices, and increases nominal & real interest rates. It supports investment & risk assets, making borrowing more attractive. The yield curve steepens, meaning long-term interest rates rise more than short-term ones, signaling economic growth expectations. Key takeaway: When well-executed, fiscal policy stimulates economic activity and encourages investment. Ineffective Fiscal Policy If people believe the stimulus is temporary, they increase savings instead of spending. This offsets government spending, leading to no significant impact on economic activity. Example: If people expect future tax hikes, they save more, canceling out the stimulus effect. Key takeaway: Fiscal policy fails when expectations neutralize its effects. Loss of Control (Hyperinflation & Crisis) ⚠ Week 2 4  If governments print too much money to finance deficits, inflation spirals out of control. Markets lose confidence, causing: Rapid inflation Currency depreciation Higher interest rates Market collapse This is common in emerging markets with weak institutions. Key takeaway: Excessive fiscal easing can destroy economic stability and investor confidence. Key Takeaways Recap The "Magic Factors" Behind Fiscal Policy Effectiveness The Multiplier Effect & Fiscal Policy Fiscal policy impacts the economy through the multiplier effect, meaning an initial change in spending leads to a larger overall economic impact. Tax Cuts  More disposable income → Higher consumption & output Government Spending Increases  More public demand → More inflation risk Infrastructure & Education Investment  Higher long-term productivity & GDP growth Key takeaway: The type of spending determines whether fiscal policy leads to short-term growth or long-term structural change. Week 2 5  Government Purchases & Multipliers Fiscal policy works in two stages:  Autonomous Effect → Direct increase in demand (e.g., government buys roads = construction jobs).  Induced Effect → Higher income leads to more consumer spending, increasing overall GDP. Example: If the government spends $100 billion, the economy may expand by more than $100 billion due to secondary spending (consumption ripple effects). Key takeaway: Government spending creates a chain reaction where one dollar spent leads to multiple dollars of economic activity. Example: How the Fiscal Multiplier Works Suppose the government spends $100 billion on infrastructure. Workers get paid and spend $50 billion on goods and services. That $50 billion generates further spending of $25 billion, and so on. Over time, total GDP increases by more than $100 billion (due to successive rounds of spending). Key takeaway: The stronger the multiplier, the greater the total economic impact of fiscal policy. Key Takeaways Recap Week 2 6  Detailed Summary of Fiscal Policy Slides Objectives of Fiscal Policy Fiscal policy aims to achieve three key goals: Week 2 7  Stabilization Influences aggregate demand AD directly and indirectly. Formula: Key Components: C  Consumption I  Investment G  Government spending X  Exports m  Imports Impacts output, employment, inflation, and balance of payments. Allocation Affects aggregate supply via public investment: Infrastructure Education Healthcare Distribution Taxes & transfers determine income distribution: Progressive Higher earners pay more. Regressive Lower earners pay more. Neutral No impact on inequality. Stabilization Policy & Economic Balance Internal Balance Full employment & price stability. Week 2 8  If demand is too low → Recession (high unemployment). If demand is too high → Inflation (rising prices). External Balance Ensures a sustainable balance of payments. Prevents excessive foreign debt. Fiscal Policy & National Income Accounting Key Equations: Meaning: If the govʼt spends more than it taxes, it must finance the deficit via:  Private savings  Foreign borrowing Expansionary vs. Contractionary Fiscal Policy Expansionary (Stimulus) Used when GDP is below potential. Methods: Increase govʼt spending Cut taxes Effect Boosts AD  Lowers unemployment. Week 2 9  Contractionary (Cooling Down) Used when GDP is above potential. Methods: Reduce govʼt spending Raise taxes Effect Lowers inflation by reducing AD. The Multiplier Effect How fiscal policy amplifies effects: If the govʼt spends $100B, total impact is larger due to re-spending cycles. Formula: Fiscal Policy Results Effective Boosts output, lowers unemployment, and increases investment. Ineffective If seen as temporary, people save instead of spending. ⚠ Loss of Control Excessive deficits  Inflation , rising interest rates, and currency depreciation. Week 2 10  Factors Affecting Fiscal Multipliers Openness of the Economy Open economies More imports reduce the impact of government spending. Closed economies Spending stays domestic, leading to a higher multiplier. Exchange Rate System Fixed exchange rate Fiscal policy has stronger effects. Floating exchange rate Exchange rate adjustments may offset the impact. Budget Financing Money creation (printing) → Inflationary. Debt-financed spending  Impact depends on interest rates & investor confidence. Confidence in Economic Policy Higher government debt  Less room for spending. Financing constraints  Limited ability to borrow. Risk premiums on debt ⚠  Higher interest rates reduce investment. Perception of Fiscal Changes Temporary changes  Small effect (people anticipate reversal). Permanent changes  Stronger response (adjustment in spending & investment). Employment Levels If full employment  Stimulus causes inflation instead of growth. If recession  Fiscal policy has stronger effects. Conclusion: Fiscal multipliers vary based on these conditions. Best scenario Low debt, fixed exchange rate, and a closed economy. Week 2 11  Worst scenario High debt, floating exchange rate, and an open economy. Basic Idea We are calculating the output Y of a country in an open economy, meaning it trades goods and services with other countries. Key Concepts:  Y  Output (what the economy produces).  C  Consumption (what people spend).  I  Investment (business spending).  G  Government spending.  X  Exports (goods sold to other countries).  M  Imports (goods bought from other countries). Step 1: Internal Consumption (C) C  a(Y  T  b a = how much people spend out of their income (a %). Y  T = disposable income (income minus taxes). b = basic consumption (people spend some money even if their income is zero). Step 2: Imports (M) Imports depend on the economy's output: M  μY μ  % of output spent on imports. Step 3: Output Equation Combine everything: YCIGXMYCIGXM Step 4: Plug in the Details Substitute C and M into the equation: Y=a(YT)+b+IGXμY Week 2 12  Y=a(YT)+b+IGXμY Rearrange terms to solve for Y. Calculating Tax Multiplier What is Happening? Week 2 13  This slide explains how taxes T affect the economy's output (Y) and how to calculate the tax multiplier. Key Ideas:  Y  Output (the economy's total production or income).  T  Taxes (money taken by the government).  Tax Multiplier tells us how much Y (output) decreases when T (taxes) increases. The Equation: We start with this basic formula for an economy: Y=a(YT)+b+IG Y=a(YT)+b+IG a(Y  T People spend a part of their income after paying taxes (disposable income). a is the percentage of disposable income that people spend (called Marginal Propensity to Consume, or MPC. b: People always spend a small fixed amount, no matter their income. I  G Investments and government spending, which add to the economy. Rearrange the Equation: Rearrange the terms so all Y terms are on one side: Y[1−a]=b+IG−aT Y[1−a]=b+IG−aT Week 2 14 Week 2 15  The Multiplier Effect in Different Views The multiplier is a chain reaction effect: when the government injects money (spending, investment, etc.), this money circulates in the economy, creating further increases in economic activity. Different multipliers exist: Investment multiplier  If the government invests, businesses get money, which they use to pay workers, who then spend more. Government expenditure multiplier  When the government increases spending, GDP rises more than proportionally. Export multiplier  If exports increase, money flows into the economy, boosting income and consumption. Leakages  The size of the multiplier depends on how much money "escapes" from the economy: Savings S Taxes T Imports M Formula overview: The more leakages there are, the smaller the final GDP increase. Week 2 16  Calculating the Tax Multiplier Step-by-Step Formula Breakdown:  Start with national income equation: Y  National income T  Taxes a  Marginal Propensity to Consume MPC  fraction of income spent b  Autonomous consumption (spending even with no income) Simple vs Complex Tax Multipliers Week 2 17  More realistic since tax cuts can affect all GDP components: MPC  Marginal Propensity to Consume MPT  Marginal Propensity to Tax MPI  Marginal Propensity to Invest MPG  Marginal Propensity for Government Spending MPM  Marginal Propensity to Import The more leakages (savings, imports, taxes), the lower the multiplier. The Fiscal Multiplier in the Real World The relationship between spending and GDP growth is messier than theory suggests. Not everyone has the same MPC! Low-income people have high MPC → they spend most of their income. High-income people have low MPC → they save more. Thatʼs why policies targeting low-income individuals (like food stamps) tend to have a higher fiscal multiplier. Impact of policy types: Temporary policies (food stamps, unemployment benefits) have high multipliers 1.64  1.73. Week 2 18  Permanent tax cuts (corporate tax, capital gains tax) have low multipliers 1 because high earners save more instead of spending. Fiscal Multipliers for Different Policies Summary Table – Key Takeaways Final Notes If the economy is in a recession, government spending G is more effective than tax cuts to boost GDP. If the economy is overheating (inflation too high), increasing taxes or reducing spending helps cool it down. A high fiscal multiplier means government intervention is very effective at stimulating growth. Week 2 19  Modern Views on the Fiscal Multiplier The fiscal multiplier has not always been a widely accepted tool in economic policy. Its influence has waxed and wanedover time, depending on economic conditions and prevailing schools of thought. How Views Have Changed Over Time Until the 1960s, Keynesian economics dominated. The belief was that government spending had a strong multiplier effect on economic growth. 1970s Stagflation (high inflation + stagnation) challenged Keynesian theory. Many policymakers shifted to monetarism, which emphasized money supply control over fiscal spending. After the 2008 Financial Crisis, fiscal policy made a comeback. The U.S. used fiscal stimulus aggressively and recovered faster than Europe, where austerity measures slowed growth. Key Idea: The effectiveness of fiscal policy depends on the economic environment and policymakers' beliefs. Stagflation weakened trust in fiscal spending, but the 2008 crisis restored confidence in it. Structural Characteristics Affecting Fiscal Multipliers Different structural factors determine how strong a fiscal multiplier is in a given country. Some increase its impact, while others reduce it. Key Structural Factors Trade Openness Countries that import a lot (i.e., small open economies) tend to have lower multipliers because spending leaks out to foreign producers. Larger economies with fewer imports have higher multipliers since more spending stays inside the country. Labor Market Rigidity Strict labor laws and strong unions = higher multipliers because wages remain stable and prevent immediate economic downturns. Flexible labor markets (where wages adjust quickly) = lower multipliers because workers might get lower wages instead of stable Week 2 20  employment. Automatic Stabilizers High automatic stabilizers (e.g., social security, unemployment benefits) reduce fiscal multipliers because they offset economic shocks automatically. Lower automatic stabilizers = higher fiscal multipliers because fiscal stimulus has a stronger effect. Exchange Rate Regime Flexible exchange rates weaken the fiscal multiplier because currency depreciation offsets stimulus effects. Fixed exchange rates support higher multipliers since the government can't use monetary policy to counteract fiscal actions. Debt Levels High government debt = lower multiplier because markets lose confidence, and higher borrowing costs offset fiscal stimulus. Low debt = higher multiplier since governments can spend more without raising concerns. Key Idea: Countries with rigid labor markets, low trade openness, and fixed exchange rates tend to benefit more from fiscal stimulus, while high- debt, highly open economies with flexible exchange rates see smaller effects. Factors Increasing vs. Decreasing Multipliers in Emerging & Low-Income Countries The IMF Working Paper summarizes what makes fiscal multipliers bigger or smaller in Emerging Markets EMEs) and Low-Income Countries LICs). Week 2 21  Key Idea: Developing economies can have higher multipliers when monetary policy is weak and people spend more of their income. But small economies with bad financial management and debt problems often have low multipliers. Takeaways The effectiveness of fiscal policy changes over time. Keynesian policies dominated before 1970s stagflation, lost popularity to monetarism, and regained favor after 2008. Fiscal multipliers depend on structural factors like trade openness, labor market rigidity, debt, and exchange rates. Emerging Markets & Developing Countries often have different fiscal multiplier effects due to factors like weak financial systems, high uncertainty, and limited automatic stabilizers. Magic Factors: Timing & Crowding Out Timing Issues Fiscal policy isn't always effective due to delays: Legislative delay  Government debates take time before actions are approved. Implementation delay  Even after approval, big projects take months or years to start. Week 2 22  Crowding Out Effect When the government increases spending, private spending might fall: More government spending  Interest rates rise Higher interest rates discourage private investments Overall private expenditures decline Expansionary Fiscal Policy & Interest Rates How it Works When the government spends more, people need more money This increases demand for money  Interest rates rise As a result, consumption, investment, and net exports fall Key takeaway: More government spending doesnʼt always mean economic growth because it can increase borrowing costs and reduce other types of spending. The Effect of Crowding Out in the Short Run Government spends more (expansionary policy)  Aggregate Demand AD shifts right But higher interest rates reduce private spending  Some of that AD shift is lost The final effect? AD doesnʼt rise as much as expected because private investment shrinks Graph: The initial shift in AD is larger But due to crowding out, AD shifts less than expected Crowding Out in the Long Run In the long run, GDP returns to its natural level Increased government spending reduces consumption, investment, and net exports Week 2 23  The economy naturally corrects itself without intervention Big takeaway: Fiscal stimulus works in the short run but in the long run, the economy adjusts back to its normal state. The government just gets bigger without changing GDP growth in the long term. Week 2 24  Week 3 - Fiscal Policy Evaluation Problems with Proper Timing (Time Lags)  Recognition Time Lag Policymakers first need to identify an economic problem, like a recession or inflation. This process takes 9 to 18 months because economic data is collected after events happen. The challenge? We can't perfectly predict the future.  Action Time Lag Even after recognizing the issue, governments take time to debate and implement policies. Monetary policy (changing interest rates) is faster than fiscal policy. Fiscal policy (government spending/taxes) takes longer due to political debates and approvals.  Effect Time Lag Even after implementation, it takes time for policies to impact the economy. A stimulus package today might only show effects months or years later. Problems with Proper Timing (Economic Stability) Fiscal policy is a double-edged sword. If timed correctly, it can help stabilize the economy. If mistimed, it might make things worse. Example: If a government increases spending too late, the economy might already be recovering, leading to inflation rather than growth. Business Cycle Graph: Week 3  Fiscal Policy Evaluation 1  Goal of fiscal policy? To smooth out the peaks and troughs, preventing severe recessions and overheating. One Solution: Automatic Stabilizers Discretionary vs. Automatic Fiscal Policy  Discretionary Fiscal Policy  Requires active government decisions (e.g., stimulus checks, tax cuts).  Automatic Stabilizers – Work automatically without new government action. What Are Automatic Stabilizers? Definition Policies that adjust automatically to economic changes without requiring new laws. Purpose: Reduce the severity of recessions and slow down overheated economies. Examples: Progressive taxes When income falls, people pay less tax → keeps spending stable. Unemployment benefits When people lose jobs, they get financial aid → keeps consumption going. Price stabilization funds: Limit extreme price changes. Why are they useful? They act instantly, avoiding the timing problems of discretionary policies. Week 3  Fiscal Policy Evaluation 2  How Automatic Stabilizers Work in Different Phases of the Economy During a Recession People lose jobs → Unemployment benefits help them survive. Income falls → Taxes automatically decrease, letting people keep more money. Effect Helps reduce the impact of the downturn. During an Overheated Economy Wages rise, employment increases → More people pay higher taxes. Less need for unemployment benefits  Government spends less. Effect Slows down excessive growth and prevents inflation. Graph: Automatic Stabilizers in Action Budget Deficit Y2 Lower taxes + higher unemployment benefits  Helps lessen a recession. Budget Surplus Y1 Higher taxes + lower unemployment benefits  Helps slow down an overheated economy. Key Idea: Automatic stabilizers naturally bring the economy back toward full employment without government intervention. Automatic Stabilizers in the EU How strong are they? 35% of income loss is absorbed on average by the tax and benefit system. Example If income drops by 1%, disposable income only falls by 0.65% because of automatic stabilizers. Variation Some countries have stronger stabilizers (e.g., Austria 45%, others weaker (e.g., Bulgaria 20%. Week 3  Fiscal Policy Evaluation 3  Consumption Stabilization in the EU Even stronger than income stabilization: 70% of consumption loss is absorbed in the EU by taxes, benefits, and reduced savings. Consumption only drops 30% when income falls. Why? Households reduce savings when their income falls, helping keep spending stable. Key Difference: Income stabilization prevents sharp income losses. Consumption stabilization prevents demand from collapsing. Final Graph: Market Income Shocks & Stabilizers Shows how much of a market income shock is absorbed by stabilizers. Netherlands, Germany, Austria = best stabilizers (over 70% of shocks absorbed). Japan, Greece, Spain = weaker stabilizers 4050% absorbed). Key components of stabilization: Direct taxes (green) Unemployment benefits & family benefits (blue) Social security contributions (red) Key Takeaway Countries with strong stabilizers experience less economic volatility during crises. Summary Table Week 3  Fiscal Policy Evaluation 4  Fiscal Position/Balance Fiscal balance is the difference between a government's revenues (taxes, asset sales) and its expenditures (spending). It's usually expressed as a percentage of GDP Gross Domestic Product). A positive balance means a surplus (government earns more than it spends ). A negative balance means a deficit (government spends more than it earns ). Fiscal balance is used to measure financial health and the governmentʼs ability to meet its financial obligations. The Federal Government Debt (1901-2015) When the government runs a deficit, it borrows money by selling Treasury securities (essentially IOUs ). This accumulated borrowing is called the federal government debt or national debt. The national debt increases significantly during: Wars WWI, WWII Recessions (e.g., 20072009 crisis) Week 3  Fiscal Policy Evaluation 5  The debt as a percentage of GDP spiked during WWII but later declined until more recent crises. Key takeaway Governments borrow to stimulate the economy during downturns, but excessive debt can create long-term economic risks. The Federal Budget Deficit (1901-2015) The government rarely balances its budget (meaning spending = revenue). Instead, it usually spends more than it earns, especially during major crises or wars. When revenues exceed spending, a budget surplus occurs (rare ). Key trend The U.S. runs persistent budget deficits but to different degrees over time. Budget Deficits and Recessions Budget deficits grow during recessions because: Tax revenues drop (people earn less, pay less tax ). Government spending increases (welfare, unemployment benefits, food stamps ). These "automatic stabilizers" help reduce the recessionʼs impact. Economists believe the Great Depression was worse because automatic stabilizers were not widely used back then. Should We Worry About the Deficit? Imagine the U.S. government has a budget deficit of 2.7% of GDP. Questions to ask:  Is it because the economy is weak? GDP below potential)  Or is it due to government overspending? If GDP was at its full potential, the "real" budget deficit would be only 1.6% of GDP. Possible solutions: Cut government spending Week 3  Fiscal Policy Evaluation 6  Increase taxes Or let economic growth naturally reduce the deficit over time. How Should the Fiscal Position Be Assessed? Measuring a fiscal position is complex; thereʼs no one-size-fits- all method. Challenges: Economic conditions vary Indicators can be flawed The IMF Government Finance Statistics Manual GFSM 2014 provides a framework for: What should be counted in public finances (e.g., state vs. national level) When transactions should be recorded What indicators to use for assessment 1. Coverage of the Public Sector The public sector consists of different levels of government and public entities responsible for fiscal activities. These are:  Central Government  The national authority that controls policies and budgets at the highest level. This includes ministries, government agencies, and any autonomous organizations that operate under the control of the central government.  Subnational Governments  Local or regional authorities such as states, provinces, or municipalities. They have their own budgets but are still part of the overall government structure.  Social Security Funds  These are financial pools dedicated to pension systems, unemployment benefits, and healthcare. They may function independently or be integrated into the central or general government.  Public Corporations  State-owned enterprises SOEs) that operate in sectors such as transport, energy, and banking. These can be either: Financial public corporations (e.g., central banks) Week 3  Fiscal Policy Evaluation 7  Non-financial public corporations (e.g., national railway companies). Why Is Public Sector Coverage Important? It helps determine the governmentʼs fiscal responsibilities and risks. Some levels of government (e.g., local authorities) must maintain a balanced budget, meaning they cannot run deficits. Public corporations can create fiscal risks, so their operations should be monitored. Policy & Fiscal Transparency Fiscal policy should account for both government operations and public corporations to assess economic risks properly. Good data collection improves transparency and helps prevent financial crises by tracking government spending, revenue, and liabilities. This structured approach ensures that public finances are properly monitored, transparent, and accountable to avoid hidden risks that could destabilize the economy. 2. When to Record Government Transactions Governments record transactions in four different ways, depending on how they track their spending and revenue:  Commitment Basis  A transaction is recorded when the government commits to it, such as when they issue a purchase order. Example: If the government orders new trains, the transaction is recorded when the contract is signed, NOT when the trains arrive).  Accrual Basis  A transaction is recorded when the economic event actually happens. For example, when a company delivers a service or a good, even if payment happens later.  Due-for-Payment Basis  Transactions are recorded at the latest moment possible before incurring penalties. Example: If a government needs to pay a contractor, it records the transaction when the last legal deadline approaches).  Cash Basis  The simplest one! Transactions are only recorded when cash is received or paid. Week 3  Fiscal Policy Evaluation 8  Why does this matter? Some countries, especially those with weaker financial systems, rely on the cash basis because itʼs easier to manage. But this can distort how the government sees its financial health because it doesnʼt consider future payments. Cash-based systems ignore unpaid bills (arrears) and noncash benefits (like food stamps), which means they donʼt give a full picture of government obligations. Even with accrual-based accounting, cash flow monitoring is still crucial to ensure the government can pay its bills and manage liquidity. Some governments modify cash-based systems to include transactions that are technically "due" but not yet paid (for example, interest owed but not yet paid). Key takeaway: Cash-based systems are simpler but may hide financial risks. Accrual and due-for-payment bases provide a better long-term picture but require more complex accounting. 3. Main Fiscal Indicators Fiscal position is assessed using two types of indicators:  Flow indicators These measure economic activities or transactions over a specific period, like a fiscal year or a quarter. Example: Government revenue and expenditures in 2024.  Stock indicators These measure the value of assets and liabilities at a particular point in time, like at the end of a fiscal year. Example: The total national debt at the end of December 2024. Flow Indicators: Understanding Fiscal Balance  Overall Fiscal Balance Week 3  Fiscal Policy Evaluation 9  The most common fiscal indicator. It is calculated as:Total revenue (including grants)  Total expenditures  Lending  Repayments It reflects how much the government needs to finance its operations.  Adjusted Overall Fiscal Balance This excludes revenue sources that are volatile or specific to certain sectors (e.g., oil revenues, grants). Helps in understanding the fiscal sustainability without temporary income sources. Why does this matter? External grants are unpredictable and don't reduce domestic demand. The government may show a surplus if grants are included but actually have an unsustainable fiscal position without them. Adjusted Overall Fiscal Balance: Factors to Consider  Oil and other non-renewable resources Oil revenue is highly volatile and non-renewable, so relying on it is risky. Countries dependent on oil should focus on their non-oil balance to measure their true fiscal health.  Privatization Receipts Revenue from selling state-owned assets is often excluded from fiscal balance, as it is a one-time income.  Externally Financed Projects Some infrastructure or development projects funded by foreign loans are excluded because they donʼt affect domestic supply directly but increase debt.  Domestic Balance Excludes grants, externally financed spending, and interest payments. More accurate for evaluating long-term fiscal sustainability. Two Key Indicators of Fiscal Balance Week 3  Fiscal Policy Evaluation 10   Primary Balance This is revenue minus non-interest (primary) expenditures. It shows how well the government is managing its finances before considering debt payments. A positive primary balance means the government is covering its expenses before debt payments.  Operational Balance Itʼs the overall balance adjusted for inflationʼs impact on debt. Important in economies with high inflation to see real government debt burden. Why are these indicators useful? Primary balance helps in understanding if debt is sustainable. Operational balance is useful when inflation is high, as it corrects for the eroding value of money. Key Takeaways  Fiscal position is assessed using flow (transactions over time) and stock (assets/liabilities at a point).  Overall fiscal balance shows the governmentʼs revenue vs. expenditure.  Adjusted balance removes unpredictable income (e.g., grants, oil) for a clearer picture.  Primary balance measures financial health before interest payments, while operational balance adjusts for inflation. If a country has a surplus only because of grants or oil revenues, it might not be truly financially stable! Primary Balance The Primary Balance is a way to measure the government's fiscal health without considering interest payments on debt. The Overall Deficit formula is: Week 3  Fiscal Policy Evaluation 11  where: G  Total government expenditure Gⁿ  Non-interest spending (on public services, wages, etc.) Gⁱ  Interest expenditure (money spent on paying interest on debt) T  Total government revenues (taxes, etc.) i  Interest rate on government debt Dⁱ  Outstanding government debt Simplifying, we get the Primary Deficit: This shows that the primary deficit focuses only on spending and revenue, excluding interest payments. Operational Deficit The Operational Deficit adjusts the primary deficit by removing inflation's impact on interest payments. The formula: where: π (pi) = Inflation rate r  Real interest rate (interest rate adjusted for inflation) i  Nominal interest rate The key relationship: r ≈ i − π This means that if inflation (π) is high, the real interest rate (r) is lower. Week 3  Fiscal Policy Evaluation 12  Why is this important? Governments use operational deficit to understand the real burden of their debt, ignoring the inflation effect. If inflation is high, some of the debt burden disappears naturally because the real value of the debt decreases. Key Takeaways  Primary Balance  Budget balance before interest payments (used for fiscal discipline).  Operational Deficit  Primary deficit adjusted for inflation, used to measure the true economic impact of government borrowing.  If inflation is high, real debt burden decreases, but high inflation can cause other economic problems. 3) Flow Indicators: Cyclically Adjusted Balance The cyclically adjusted balance is a way to measure the governmentʼs fiscal position without the effects of economic cycles. It removes the cyclical component (temporary ups and downs caused by economic booms or recessions) from the nominal fiscal balance. The cyclical component depends on: Output gap The difference between actual and potential GDP. Budget elasticity How government revenues (like taxes) and spending (like welfare payments) react to economic fluctuations. Why does this matter? Budget targets are rarely set in cyclically adjusted terms. Itʼs complicated to calculate because it requires estimating how government revenues and expenses react to economic changes. Despite these difficulties, it is a useful reference for fiscal policy design and implementation. 4) Flow Indicators: Augmented Balance & Gross Financing Needs Augmented Balance Week 3  Fiscal Policy Evaluation 13  This is the overall balance but includes exceptional one-time expenses that wouldnʼt usually appear in standard budget calculations. Example: Costs of bank bailouts or corporate restructuring. These unexpected expenses must still be financed and can have a big impact on economic demand. Gross Financing Needs & Sources What is it? This tracks how much money the government needs to finance its operations. It includes the deficit, debt repayments, and other financing needs. Why is it important? It helps identify liquidity issues —if the government needs too much money, it might have trouble borrowing or repaying debts. If a government suddenly needs more external financing than usual, it could lead to liquidity problems. Stock Indicators Definition & Importance Fiscal policy traditionally focused on flows (income & expenses) but stocks (assets & liabilities) are also key. Understanding stocks helps check the quality of fiscal data and provides a big-picture view of government finances. Public Balance Sheet Components Assets: Financial (e.g., government deposits in banks) Non-financial (e.g., roads, infrastructure) Liabilities: Government debt Net worth (difference between assets & liabilities) Week 3  Fiscal Policy Evaluation 14  Liabilities & Net Worth Liabilities = mostly government debt If liabilities grow too fast relative to GDP or revenue, the country could have trouble repaying debt. Net Financial Worth Recognizes that liabilities may be offset by financial assets. BUT only liquid financial assets can be used to pay debts (e.g., govʼt deposits in banks, not hard-to-sell assets like state-owned companies). Net Worth More comprehensive: includes non-financial assets (e.g., land, infrastructure). Harder to measure accurately since valuing non-financial assets can be tricky. Hidden Government Risks & Responsibilities ⚠ Contingent Liabilities Indirect risks that may or may not happen but can impact fiscal health (e.g., loan guarantees, bailout promises). These are often hidden but can be expensive if they materialize. Public-Private Partnerships PPPs) Private sector funds a public project, and the government repays over time. Can increase efficiency but also hide government debt, making public finances look healthier than they really are. Risk: Governments may underestimate future costs and over-rely on private financing. Solution: Greater transparency in budget documents & reports. These stock indicators help governments measure long-term financial health rather than just looking at yearly revenues and expenses. Fiscal Space Week 3  Fiscal Policy Evaluation 15  What is Fiscal Space? Fiscal space refers to the financial "room" a government has in its budget to spend on new priorities without risking its financial stability. Governments can create fiscal space by: Raising taxes Securing grants Cutting lower-priority spending Borrowing domestically or internationally Borrowing from the banking system (which expands the money supply) Key challenge: A government must increase fiscal space without harming macroeconomic stability (i.e., making sure the economy can handle the additional spending and debt). Ensuring Sustainable Fiscal Space If a government increases spending, it must also think about future costs, e.g.: Recurring costs (maintenance of infrastructure , running schools , hospitals ) Debt sustainability—can the country repay without economic damage? Debt-financed spending should be analyzed carefully: How does it affect economic growth ? Can the country generate enough revenue to pay it back? Avoiding "Crowding Out" ⚠ If too much money is spent on one area (e.g., healthcare ), other productive investments (e.g., business support ) may suffer. How to Create More Fiscal Space? Governments can increase fiscal space in different ways: Reprioritizing expenditure (shifting funds to more important sectors) Week 3  Fiscal Policy Evaluation 16  Boosting efficiency (reducing wasteful spending) Raising revenue (increasing taxes or finding new revenue sources) Rational borrowing (borrowing only when the return is worth the cost) Monetary expansion (risk: may cause inflation ) Getting more external grants (securing funds from other countries or institutions) Maintaining sound macroeconomic policies (balancing the economy correctly) Measuring Fiscal Space There are two main ways to assess fiscal space: Market Access Can the country keep borrowing safely? Debt limits (risk of default) Current debt levels Interest rates (cost of borrowing) Economic growth potential Sustainability Can the country afford its debt in the long run? Spending vs. Revenue balance Impact of debt on economic stability Structural reforms (long-term financial improvements) Fiscal space is the balance between these two forces—governments need to borrow wisely while ensuring long-term economic stability. Fiscal Space Assessment Overview Assessing fiscal space is a complex process that involves multiple methodologies and various international institutions such as the IMF, World Bank, OECD, and Moodyʼs. These entities analyze fiscal sustainability using different frameworks. Four Key Stages of Fiscal Space Assessment Week 3  Fiscal Policy Evaluation 17   Cyclical and Structural State of the Economy Evaluating economic conditions to determine fiscal sustainability.  Availability of Favorable Financing Examining the ease with which a government can secure financing at reasonable rates. Assessing how market perceptions impact funding costs.  Sustainability of Debt and Deficit Trajectory Determining if public debt levels and budget deficits can be managed over the medium and long term.  Sensitivity to Debt and Financing Needs Analyzing how fiscal sustainability holds up under stress tests and expansionary fiscal policies. Macroeconomic Context and Market Access A crucial part of fiscal space assessment involves understanding macroeconomic conditions, including: Domestic and external factors. Structural gaps (e.g., GDP gap). Risk premiums associated with fiscal actions. Additionally, market access and debt sustainability are assessed based on: The availability of financing. Debt burdens. Fiscal adjustments needed over time. Dynamic Analysis of Expansionary Fiscal Policy Simulating fiscal policy decisions Governments model different fiscal policies to predict their economic impact on GDP, inflation, and debt. Trade-offs between growth and debt Week 3  Fiscal Policy Evaluation 18  Standardized assumptions help policymakers determine how discretionary fiscal policy will affect economic stability. Country-specific adjustments Each countryʼs economic conditions influence how fiscal policies are designed and assessed. Final Judgment Ultimately, international institutions and government agencies apply expert judgment to determine the degree of fiscal space. This is done by analyzing: Data from the assessmentʼs previous stages. Country-specific indicators and factors. Additional analytical tools to refine fiscal space estimations. This assessment helps policymakers make informed decisions on debt management, financing strategies, and long-term fiscal sustainability. Week 3  Fiscal Policy Evaluation 19  Week 4 - Fiscal Policy and Crisis Debt Accumulation: A Vicious Cycle Debt keeps growing because of interest payments. A country that has a lot of debt must pay high interest. Since these payments add to the deficit, the government borrows even more money, making things worse. This can create a vicious cycle where: Budget Deficit (spending more than revenues) More borrowing (financing the deficit) Debt increases Higher interest payments Even bigger budget deficits Key question: How can we tell if a countryʼs debt will spiral out of control? We need some arithmetic! Operational Budget Deficit Formula Basic equation for the deficit (ΔD D  Total government debt G^N  Non-interest government spending (roads, education, military, etc.) r  Interest rate on debt T  Taxes collected Simplification: If the government collects exactly as much tax as it spends on services, T  G^N, so the formula simplifies to: Week 4  Fiscal Policy and Crisis 1  Meaning: Debt grows just by accumulating interest! If you already owe a lot, it automatically gets worse if the interest rate is high. Takeaway: The debt grows exponentially if nothing is done to stop it! Linking Debt Growth to Economic Growth We already have: This means debt is growing at the interest rate. Now, assume that the economy GDP, denoted as Y also grows at a rate g: This means the economy is also expanding, which helps absorb debt. Key step: Subtract GDP growth from both sides: Debt-to-GDP ratio D/Y changes depending on the difference between r (interest rate) and g GDP growth). Key Insight: If r > g, debt grows faster than the economy (Bad) If g > r, economy grows faster than debt Good) If they are equal, debt stays stable. Week 4  Fiscal Policy and Crisis 2  Understanding Debt Ratio Changes What does this formula really mean? It represents the change in the debt-to-GDP ratio. Using a simple math rule: This tells us that the debt ratio grows only when debt grows faster than the economy. Final thought: Debt is manageable if economic growth keeps up. If the economy stagnates but interest rates stay high, debt gets out of control fast! Proof Using Logarithms (Optional for Math Fans) Defining a ratio: Taking logs (logarithms make multiplication into addition for easier analysis): Week 4  Fiscal Policy and Crisis 3  This proves that the debt-to-GDP ratio follows the rule we saw earlier! Final Message: This proves mathematically that debt only becomes a problem when it grows faster than GDP. Exam Takeaways  Debt grows because of interest payments if there is no surplus to cover them.  The key to sustainable debt is economic growth. If GDP grows faster than interest, the debt burden decreases over time.  If r (interest rate) > g GDP growth), the countryʼs debt will become a big problem.  Debt-to-GDP ratio tells us if a country is in trouble or not. Debt Ratio and Economic Growth vs. The debt ratio (d=D/Y, i.e. debt relative to GDP follows: r = interest rate on debt g  GDP growth rate What does this mean? The debt ratio depends on the difference between interest rate (r) and economic growth (g): Week 4  Fiscal Policy and Crisis 4  r > g → Debt-to-GDP ratio increases BAD r = g → Debt-to-GDP ratio stays stable OK r < g → Debt-to-GDP ratio decreases GOOD Key Insight If the economy grows faster than the interest rate, the debt becomes easier to manage over time. When is Debt Sustainable? Debt is sustainable if economic growth is at least as high as the interest rate ( g≥r ). g≥r Key takeaways: Economic growth is crucial to keep debt from exploding. If interest rates rise, debt can become unsustainable very quickly. Main Idea: A high GDP growth rate is the best way to manage debt levels! Budget Constraint & Debt Evolution Formula to track debt over time: D  Total debt i  Nominal interest rate PB  Primary balance (budget surplus or deficit without interest payments) By dividing by nominal GDP, we get: Week 4  Fiscal Policy and Crisis 5  What does this mean? If r > g → debt-to-GDP ratio rises. If r = g → debt ratio stays the same. If r < g → debt ratio falls. Key Point Countries can reduce their debt-to-GDP ratio by running a primary surplus (positive PB or having high GDP growth. Long-Run Debt Ratio Final Insight: Reducing the primary deficit PB is key to stabilizing or reducing debt. If g > r, even a small deficit is manageable. If g < r, the only way to control debt is by running a primary surplus (cutting spending or raising taxes). Final Exam Takeaways Debt is manageable if GDP grows faster than interest rates. Countries must either control deficits or boost economic growth to avoid debt spiraling. Week 4  Fiscal Policy and Crisis 6  If interest rates rise too much, debt can become unsustainable quickly. A primary surplus helps stabilize debt in the long run. If you see a question on debt sustainability, just check: g ≥ r ? Debt is fine. g < r ? Need a primary surplus to avoid a crisis. Fiscal Stimulus and Crises of Confidence When a country has high deficits and rising public debt, government spending can lose effectiveness or even make things worse. Why? People expect a future fiscal crisis, meaning: They fear higher taxes later, so they start saving more now. This reduces consumption, slowing the economy. Fiscal stimulus might fail or even backfire. On the other hand, cutting spending (fiscal contraction) might restore confidence, helping the economy recover. Key Concept: Ricardian Equivalence This theory suggests that people anticipate future taxes and adjust their behavior accordingly. So, if the government spends more today, people save more instead of spending, making stimulus less effective. The Paradox of Thrift Basic idea If everyone tries to save more, total spending falls, and the economy shrinks. Keynesian economists warn that excessive saving can cause a recession: Businesses sell less, so they cut production. That leads to job losses, lower wages, and even less spending. In a crisis, saving too much can make things worse for everyone! Bottom line: Saving is good for individuals but bad for the economy if everyone does it at the same time. The Paradox of Excessive Consumption Week 4  Fiscal Policy and Crisis 7  The opposite problem: If people spend too much and donʼt save enough, they accumulate debt. Short-term boost to aggregate demand AD, but long-term financial instability. Even though incomes in the U.S. have been historically high, financial stress is rising due to debt. Big issue A consumption-driven economy canʼt be healthy if households are drowning in debt. Household Debt & the 2008 Financial Crisis Household debt-to-income ratio skyrocketed since the 1980s, peaking at 130% in 2007. After the Great Recession 20082009, household debt fell but remained high. Why does this matter? People with too much debt canʼt spend more during a crisis. Even when governments tried to stimulate the economy, people paid off debt instead of spending. Lesson from 2008 A debt crisis makes fiscal stimulus less effective. The 2008-2009 Recession & Household Debt High household debt made the recession worse: People were reluctant to spend even when they got tax cuts. Government stimulus (tax rebates, spending) had a weaker effect. Even huge deficits 10% of GDP didnʼt bring a fast recovery. Unemployment stayed high for years. Big Takeaway When people are already in debt, giving them more money wonʼt make them spend more—theyʼll just pay off debt instead. Final Exam Cheat Sheet "Too much saving = recession risk Paradox of Thrift)" Week 4  Fiscal Policy and Crisis 8  "Too much spending = financial crisis risk Paradox of Excessive Consumption)" "Fiscal stimulus might fail if people expect future taxes Ricardian Equivalence)" "2008 Crisis Lesson: High debt makes stimulus ineffective" Fiscal Stimulus: Advanced vs. Developing Countries Different countries use stimulus in different ways: Developing economies  Spend 46% on infrastructure but only 3% on tax cuts. Advanced economies  Spend only 15% on infrastructure but 34% on tax cuts. Why? Developing countries need better roads, bridges, and energy systems to boost growth. Advanced economies focus on tax cuts to stimulate private sector spending. Key Takeaway: Developing countries prioritize infrastructure, advanced economies rely more on tax cuts. Do Fiscal Stimulus Packages Work? (Fiscal Multipliers) No clear agreement among economists about how much fiscal stimulus actually boosts GDP. IMF estimates of fiscal multipliers (how much GDP grows for every €1 of government spending): 1.5  1 for large countries. 1  0.5 for medium countries. 0.5 or less for small open economies (because they rely more on trade and capital flows). Different spending types have different effects: Week 4  Fiscal Policy and Crisis 9  Transfers & tax cuts → smaller multipliers (people may save instead of spend). Investment spending → higher multipliers (creates jobs & boosts demand). Danger of Negative Multipliers: If the stimulus weakens confidence in a countryʼs ability to repay debt, it can backfire! Key Takeaways: Government spending can help, but effectiveness varies by country size & policy type. Too much stimulus can actually hurt if markets lose confidence in fiscal sustainability. Key Concepts in a Financial Crisis When a country or company faces financial trouble, four key concepts matter: Solvency : Can a country or business pay its debts in the long run? If assets > liabilities, it is solvent. Liquidity : Can it pay immediate bills (short-term debts)? A company might be solvent but still run out of cash if it canʼt access money quickly. Sustainability : A mix of solvency + liquidity + realistic financial policies. Debt should not require extreme adjustments to remain under control. Vulnerability ⚠: The risk of becoming insolvent (bankrupt) or illiquid (cash crisis). Key Takeaway Even if a country is technically solvent, it can still go bankrupt if it runs out of cash. Example: Greece in the Euro Crisis. Franceʼs Fiscal Response to COVID-19 Week 4  Fiscal Policy and Crisis 10  France spent massively to support the economy during COVID €135 billion 6% of GDP in direct crisis spending. €327 billion in loan guarantees for businesses. Key support measures:  More money for healthcare & insurance.  Tax breaks & delays for businesses.  Subsidized wages (partial unemployment payments).  Direct support for small businesses & self-employed. Additional COVID-19 Fiscal Measures in France More help for small businesses (postponed rent & loan payments). Equity investments & nationalization of failing companies (to avoid collapse). Bonuses & tax exemptions for certain workers. Extended unemployment benefits for those affected. Green economy initiatives (auto & aerospace sector support for sustainability). Key Takeaway France used a mix of direct spending, tax relief, and subsidies to prevent a total economic collapse. Post-COVID Recovery Plan Some support measures phased out as the economy reopened. However, the “Plan de Relanceˮ Recovery Plan) introduced: €100 billion investment over two years. Focus on green energy & industry competitiveness. €40 billion funded by the EU. Key Takeaway Short-term crisis response evolved into a long-term recovery plan focused on sustainability & competitiveness. Limits of Fiscal Policy After a Crisis Week 4  Fiscal Policy and Crisis 11  Government borrowing can raise interest rates, reducing private investment. Spending at full employment causes inflation, without real growth. Too much intervention can create an inflation bias in the economy. Delays in policy implementation (approval, execution) can reduce effectiveness. Key Takeaway Fiscal policy is powerful but not a magic solution. After a crisis, it must be carefully managed to avoid inflation, debt issues, and inefficiency. Exam Cheat Sheet Solvency  Long-term ability to pay debts Liquidity  Short-term ability to pay bills Franceʼs COVID19 response  Massive spending + tax relief + subsidies Post-COVID plan focused on green recovery & business competitiveness Limits of fiscal policy  Inflation, debt, and slow implementation risks Why an Exit Strategy Matters Fiscal stimulus should not be permanent. Goals of an exit strategy: Avoid creating permanent budget deficits. Commit to fiscal correction when economic conditions improve. Introduce structural reforms to promote long-term growth. Address pension & healthcare sustainability (especially with aging populations). Key Takeaway Governments must plan how to return to normal budgets once the crisis ends. The Big Question: When to Exit? Two views on timing:  Immediate budget reduction : Week 4  Fiscal Policy and Crisis 12  Pros: Reduces future debt risk. Cons: Could kill economic recovery too soon.  Delayed fiscal tightening : Pros: Gives time for a stable recovery. Cons: Investors may lose confidence if debt remains too high. Reality? The best approach is a mix of flexibility and credible commitments. Key Takeaway Cutting stimulus too early risks recession, delaying it too much risks unsustainable debt. Coordination & Definition of Exit Strategies Coordination issue: Fiscal exit should align with monetary policy exit (i.e., central bank policies). Needs international cooperation. Definition: Rolling back debt will take time (spread efforts across different policies). EUʼs Stability & Growth Pact struggles to enforce proper debt control. Example Germany constitutionalized balanced-budget rules in 2009. Key Takeaway: Debt reduction takes time and must be part of a long-term commitment. Fiscal Policy, Crises & Inequality Government spending plays a crucial role in modern economies: Education. Healthcare (big debate in the U.S.). Infrastructure (roads, airports, etc.). Some argue that fiscal policy should also address income inequality: Promote equal wealth distribution. Week 4  Fiscal Policy and Crisis 13  Poverty reduction can stimulate economic growth. Key Takeaway Government policies impact social fairness & economic performance. Inequality vs. Growth vs. Two economic perspectives:  Inequality motivates work & investment  Helps growth. ?