Macroeconomic Policy: Lecture Outline

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Macroeconomic Policy Lecture Outline 1.
Objectives of macro policy 2. Fluctuations in
business activity - historical record - causes of
business fluctuations 3. Fiscal policy - policy
instruments - financing a deficit - problems with
fiscal activism - decline of fiscal activism 4.
Sustainability of government debt
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• MACROECONOMIC POLICY
• Objectives of macro policy
• full employment
• stable prices
• steady growth
• equitable distribution of income
• balance of payments equilibrium (medium term)

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• Main focus of macro policy
• low inflation
• steady growth
• avoidance of recession
• How can these objectives be achieved?

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• Policy instruments
• 1. Fiscal policy
• govt spending (health, education, etc)
• taxation (income, expenditure, excise duties)
• income transfers (pensions, welfare)
• 2. Monetary policy
• interest rates
• money supply
• 3. Exchange rate policy
• fixed v floating

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• FLUCTUATIONS IN BUSINESS ACTIVITY
• Historical record
• recessions can be very severe
• all countries experience booms /slumps
• recessions are usually shorter than expansions
• business cycles are highly synchronised between
  partners
• - inter-country linkages
• business cycles are less severe than in past
• - govt spending is stable
• - automatic stabilisers have worked
• - active monetary policies (Greenspan after
  Asian crash)

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• Causes of business fluctuations
• unexpected shocks
• - wars, oil-prices, financial crises
• shifts in AD
• - investment is volatile (unpredictable
  behaviour)
• - price stickiness causes changes in real
  variables
• technology shifts
• - new products / new processes
• govt-induced shocks
• - poor management of fiscal / monetary policy
• - time lags

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FISCAL POLICY

• What is fiscal policy?
• - govts attempt to control AD via G and T
• Discretionary action
• change in government spending
• e.g. building new hospitals, roads, schools
• change in taxation
• e.g. tax rate, wealth tax, excise duty rates

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• Automatic stabilisers
• - kick in when economy moves into recession
• - government spending increases
• e.g. welfare payments, unemployment benefit
• - tax revenue falls in recessions (to maintain
  C)
• e.g. income tax

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Fiscal policy stance Financing government
spending G - T borrowing creation of
high-powered money G gt T deficit T gt G
surplus - surpluses occur in booms deficits
in slumps - budget deficit does not
necessarily mean that fiscal stance is
expansionary recessions cause deficits
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• Controlling aggregate demand
• fiscal activism
• - fine-tuning of AD to achieve full employment
• - fine-tuning to reduce amplitude of business
  fluctuations
• fiscal balance has replaced fiscal activism
• - fine-tuning via fiscal policy has failed.
  Why?
• - monetary policy has replaced fiscal policy
• to fine-tune the economy. Has this been a
  success?

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Problems with fiscal activism - fiscal
activism involves discretionary action -
govt has to decide how much stimulus is needed
- need to know effect of fiscal injections
(macro models used to predict effects) -
governments tend to increase G/Y ratio -
budget deficits can easily get out of hand
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Government spending / gdp
1960 1970 1990 2000 EU 32 37 48
44 Japan 17 19 32 32 USA 27 32
37 33 Germany 33 39 45 44 UK 32
34 53 44 France 35 39 51 48 Italy
30 34 53 44
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• Reasons for the decline of fiscal activism
• difficult to predict effects
• - inadequate knowledge of how economy works
• - macro models are inadequate
• - poor data
• - long time lags in policy effects
• - poor timing of policy changes

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• political interference results in wrong policy
  action
• - political cycles
• - systematic bias towards deficits
• (popularity of low taxes)
• fiscal activism results in increasing debt
• - debt/gdp ratio increases (debt has to
  financed)

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Debt / gdp ratios 1990 2000 EU
41 69 Japan 10 113 USA 32
60 Germany 42 64 France 40 64 UK
39 50 Italy 104 113
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• Reducing debt may have expansionary effects
• cut in G can lead to
• - lower interest rates
• - more confidence in govts macro policy
• - inflow of private FDI
• greater consumer / investor confidence

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• fiscal activism is useless due to crowding out
• - crowding out of private I via high interest
  rates
• - households reduce spending due to expectation
  of
• higher taxes in future
• But
• - households may not make link between budget
  deficit
• and future taxes
• - households may not care about the distant
  future
• - not much evidence to support negative impact
  of
• crowding out

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• Sustainability of debt govts worry about
  debt/gdp
• many developing countries get into trouble
  (Mexico)
• - desire for growth
• non-taxpayers / taxpayers increasing due to
• demographic time bomb
• e.g. 65
• 2000 2050
• USA 12 21
• Japan 17 30
• EU 16 28
• need to keep interest rates below gdp growth
  rate
• to get debt / gdp down (or to run a deficit
  while keeping
• debt / gdp constant)

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• Conclusions
• fiscal policy has become more conservative
• debt burden too big need for surpluses to repay
  debt
• inflationary consequences of expansionary
  policies
• financial markets nervous of increases in govt
  debt
• (Can the govt meet its debt repayments?)
• pressure to reduce size of public sector
• - efficiency gains from privatisation
• - lower interest rates
• automatic stabilisers essential for macro
  stability

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• fine-tuning replaced by coarse-tuning
• - discretionary fiscal policy still has a role
  to play
• - co-ordinated macro-policy between G7 (G3?)
• needed to keep world economy stable
• (due to high rate of transmission of economic
  shocks)