Fiscal Policy
End This Year End Last Year This YearDebt Debt General Deficit
This Year
This Year
This Year
General Expenditure / Outlays
General Revenue / Income
General Deficit
This Year This YearGeneral Deficit General Balance
IMF Fiscal Indicators
Figure 2. Sovereign Bond Yield Spreads over German Bunds(Basis points)
Sources: Bloomberg L.P.; Datastream.Note: 10-year sovereign bond yields.
0
200
400
600
800
1000
1200
1400
1600
1800
Jan -10 Ap r-10 Jul-10 Oct-10 Jan -11 Ap r-11 Jul-11
Countries w ith Programs Supported by EU/IMF
Greece
Irelan d
Po rtug al
Latv ia
Ro man ia
0
50
100
150
200
250
300
350
400
450
Jan -10 Ap r-10 Jul-10 Oct-10 Jan -11 Ap r-11 Jul-11
Selected European Countries
Sp ain
Belg iumItaly
Fin landNeth erlands
IMF Fiscal Monitor
Crisis spreads to other countries
Background Reading
1 1
1
1 (1 )
(1 ) (1 )
(1 )
t t-1
t t-1
GDPt t t
GDP GDPt-1 t t
GDPt t-1
GDPt t-1
Debt Debt
GDP GDP
Debt Debt General Deficitg
g GDP g GDP GDP
General Deficit Debtg
GDP g GDP
11
(1 )t t t
GDPt t-1 t
Debt Debt General Deficit
GDP g GDP GDP
Can you run a deficit every year?
If
then Debt-to-GDP ratio stays stable.
If > then deficit is “unsustainable”
(1 )
GDPt t-1
GDPt t-1
General Deficit Debtg
GDP g GDP
Sustainable Deficit
A growing economy allows the government to borrow some money every year and still keep debt in line with overall GDP
Primary Deficit Simplified Government Budget
Primary Expenditure (Total Expenditure less Interest Paid)
- Primary Revenue (Total Revenue less Interest Income)
Primary Budget Deficit
+ Net Interest Payments on Existing Debt
General Budget Deficit
(1 )
GDPt t-1
GDPt t-1
Primary Deficit Debtg i
GDP g GDP
t t t
t t t
General Deficit Primary Deficit Net Interest
GDP GDP GDP
Sustainable Primary Deficit
~
(1 )
Average Interest
t t-1GDP
t t-1
Net Interest Debti
GDP g GDP
• If
then stays stable.Debt
GDP
Primary Balance
%
of
GD
P
Types of Taxes
Taxes on Value Added and Imports
+ Taxes on Income and Wealth
(Income Taxes, Corporate Profits Tax, Capital Gains Taxes, Property Taxes)
+ Social Security Contributions
Total Taxes
Tax Revenues
0
5
10
15
20
25
30
35
40
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
0
5
10
15
20
25
30
35
40
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
% o
f G
DP
% o
f G
DP
GreeceGermany
Revenue Statistics - Comparative tables
http://stats.oecd.org/Index.aspx
Types of Expenditure
Consumption Expenditure
+ Compensation of Gov’t Employees
+ Gross Capital Formation
+ Social Benefits & Transfer Payments
Primary Expenditure
Goods expenditure measured in GDP
Consequences of DeficitsAusterityInflationDefault
P
YY*
AD
Austerity and the Output Gap
P*
SRAS
YP
AD′
1
2
1. Economy in LT equilibrium
2. Government imposes austerity program – cuts spending, transfers, inceases taxes
3. AD Curve shifts inward.
Recessionary Gap
Austerity has a negative effect on business cycles.
IMF
Deficits and Inflation
Government generates revenues by printing new money (referred to as seignorage).
Government facing borrowing constraints may be forced to rely on inflation tax for deficit financing and real returns to owning money.
Explain the link between deficits and inflation.
Israel 1970-1990
Inflation
0
50
100
150
200
250
300
350
400
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
Israel 1970-1990
Surplus (% of GDP)
-30.00%
-25.00%
-20.00%
-15.00%
-10.00%
-5.00%
0.00%
5.00%19
70
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
Default and RestructuringArgentina 1999-2002
IMF Study
BBC Story
Argentina GDP
4E+11
4.2E+11
4.4E+11
4.6E+11
4.8E+11
5E+11
5.2E+11
5.4E+11
1997 1998 1999 2000 2001 2002 2003 2004 2005
Stabilization policyIn an economy subject to shocks to
aggregate demand (animal spirit shocks, external shocks, asset market shocks), the economy will have a self-correcting mechanism.
However, if this self-correction mechanism takes a long time to work, then government may use policy to speed adjustment.◦Use expansionary policy to close a
recessionary gap◦Use contractionary policy to close an
inflationary gap
P
YY*
AD
Demand Driven Recession w/ Counter-cyclical fiscal policy
P*
SRAS
YP
AD′
1
2
1. Economy in LT equilibrium
2. Demand shifts in
3. Government increases spending to shift the AD curve back
3
Recessionary Gap
P
YY* AD
Demand Driven Expansion w/ Counter-cyclical fiscal policy
P*
SRAS
YP
AD′1
2
1. Economy in LT equilibrium
2. Demand shifts out
3. Government cuts spending to shift the AD curve back 3
Inflationary Gap
Lags and Fiscal Policy
Administrative lags for fiscal policy may likely be large.
Except in absolute dictatorships, government will have mechanisms for building a consensus for expenditures. Adjusting this consensus will be time consuming.
If lags are too long, stabilizing government spending or transfer payments may have a destabilizing effect, shifting out demand after the economy has already recovered.
Tax SmoothingGovernments in most economies
issue debt to make up for shortfalls in revenues in relation to spending.
Budget Deficit = Outlays – RevenuesTax collection is cyclical so the
budget deficit tends to be counter-cyclical.
Maintaining a balanced budget over the cycle means raising taxes in a recession an cutting taxes in a boom which makes the business cycle more extreme.
Learning OutcomesUse growth rate of GDP, interest
rates, and the debt to GDP ratio to identify the sustainable general and primary deficit level.
Use AS-AD model to identify the effects of fiscal policy on the output gap and the inflation rate.