Macroeconomics

5.0 Fiscal & Monetary Policy

5.1 Fiscal Policy: Tax & Spend    (MKM C15/391-413: 366-87; C16/ 384-403; 361-379)                    

While the Great Depression of the 1930s was the most severe and long lasting, it was but a single link a long chain of business cycle boom/busts dating back to the beginning of the Industrial Revolution.  Until the Keynesian Revolution of 1936 Government played little if any role in managing the national economy.  Rather the business cycle was allowed to run its course according to the 'iron law of wages'.  In the boom, labour becames scarce and wages rose.  In the bust, labour was increasingly unemployed.  Wages fell until low enough for firms to re-hire beginning the upswing of the business cycle. Meanwhile workers became increasingly desperate in the downturn.  There was no social safety net like unemployment insurance, welfare or medicare.

The Keynesian Revolution established that Government should spend in bad and save in good days.  It also dictated Government's reaction to the business cycle should be both automatic as well as discretionary. In this new architecture of public finance, automatic stabilizers are triggered by 'objective' changes in the economy and implemented automatically according to an existing Act of Parliament, e.g., if unemployment rises, employment insurance payments increase.  Discretionary fiscal policy action, on the other hand, requires debate in Parliament of proposed legislation to mandate a new fiscal policy initiative, e.g., changes in the income tax rate or increases in defense or other public spending. Such discretionary action is justified if and only if automatic stabilizers fail or are thought to fail to moderate the business cycle.  This 'moderating the business cycle' is called 'counter-cyclical fiscal policy'.  If the boom rises to fast, slow it down; if the bust falls too fast, slow it down.  A primary goal of fiscal policy, in the Keynesian sense, is to moderate the business cycle, to stabilize the economy.  And linked to moderating the business cycle is to do so while, at the same time, fostering growth in potential GDP. 

Keynes provided a tool to allow Government to stabilize the business cycle without having to do it all itself.  It is 'the multiplier'.  He also spawned a generation of economists who searched for new tools to foster growth in potential GDP, i.e., how to make the economy grow.  Growth theory is now a recognized sub-discipline of the economics profession.  The alleged failure of Keynesian economics between the 1960s and 1990s in fact represented Government choosing to spend on the upside as well as the downside of the business cycle.  This partially reflected 'policy lags', i.e., recognize a problem, fashion a solution, implement it and wait for the desired results.  In other words, the impact of some Government programs were simply out of phase with the business cycle.  However, the 'guns & butter' policy of the American Government during the Vietnam War, i.e., no special taxes were levied to pay for the war, meant Government borrowed on the financial markets and increased the national debt.  A similar guns & butter policy also characterized the second 2003 Gulf War.  Arguably, it was not Keynesian policy but politics that failed.

For those interested in the political actors involved in fiscal policy, please see: Observation #5: Economics of Democracy.  For those interested the budgetary process, please see: Observation #6: Fiscal Policy in Canada.

i - Assets, Liabilities, Revenue & Expenditures

ii -Fiscal Policy Multipliers

But  how can discretionary fiscal policy lever change the macroeconomy  - assuming potential GDP is fixed.  After the budget debate about how much pleasure and pain, the composite total (not allowing for 'distributional' effects) of tax and spend results in an increase, a decrease or no change in autonomous aggregate expenditure. An increase or decrease will change aggregate expenditure more than the initial change via  three fiscal policy multipliers assuming the short-run and a constant price level.  These are:

a) Autonomous/Government Expenditure Multiplier

b) Autonomous Tax Multiplier

c) Balanced Budget Multiplier

d) Impact of the Marginal Propensity to Import (MPM)

a) Autonomous/Government Expenditure Multiplier (GEM)
        The GEM depends on the marginal propensity to consumer (P&B 4th Ed Fig. 26.8; MKM Fig. 15.8). The higher MPC, i.e., the steeper the slope of the aggregate expenditure curve (AEC), the greater GEM. The lower MPC, the gentler the slope of the AEC, the lower GEM.  MPC, however, is assumed to be constant. GEM = 1/1-b = ∆Y/∆G.  Say the MPC is .75 then Gem is 1/1-.75 = 1/.25 = 4.  The same multiplier applies to any autonomous expenditure change, e.g., exports and investment.  The impact of GEM is, however, also affected by the slope of the Aggregate Supply Curve.  If AS is elastic GEM will be large; if AS is inelastic, small.  This is a matter of professional controversy in economics.

b) Autonomous Tax Multiplier (ATM)
        There are essentially two kinds of taxes - induced and autonomous.  Induced taxes rise and fall as real GDP varies.  The change in tax revenue is determined by the 'fixed' marginal tax rate (MRT). Taxes increase or decrease as real GDP changes.  In this way they act as an automatic stabilizer,. i.e., if GDP grows then taxes increase and transfer payments decline; if GDP declines then taxes fall and transfer payments increase.
        Autonomous taxes do not vary with real GDP rather they are fixed by Government. An increase in taxes decreases disposable income and hence consumption and therefore aggregate expenditure.  But the decrease in AE will be greater than the increase in taxes (P&B 4th Ed Fig. 26.9). The size of the ATM depends on the slope of the AEC and, hence, of the MPC.  ATM = -b/1-b = ∆Y/∆T.  If MPC is .75 then ATM is .75/1-.75 = 3 compared to 4 for GEM.  This means that a tax change has a smaller multiplier impact than an autonomous expenditure change of the same nominal amount.  This is because all of an autonomus expenditure is spent immediately while a decrease in autonomous taxes is only partially spent and partially saved (MPS). 

The inverse of the ATM is the multiplier associated with transfers. Transfers are like negative taxes, i.e. taxes are reduced. Another related concept  is 'tax expenditures' where Government selectively reduces taxes and losses revenue thereby. The autonomous transfer multiplier is simply the negative of the ATM.

c) Balanced Budget Multiplier (BBM)
        The BBM is the amount by which a simultaneous and equal change in government expenditures is matched by a change in autonomous taxes. The result is that the initial balance between government revenue and expenditure (deficit/surplus) is maintained.  The BBM requires that the effect of GEM (1/1-b) should exactly offset the effect of ATM (-b/1-b) so that ∆Y/∆G = - ∆Y/∆T

d) Impact of Marginal Propensity to Imports (MPM)

If we assume a MPC of .75, i.e., 75 cents of every dollar is spent on consumption then the GEM is 1/1-.75 = 1/.25 = 4.  If, however, the MPM is .1, i.e., 10 cents on every dollar is spent on imported goods then GEM is 1/1-.75-.1 = 1/.65 = 2.86.  This compares with a closed economy GEM of 4.

e) Automatic Stabilizers vs. Discretionary Changes (MKM C15/406-8; 381-82; 400-401)

The Keynesian model does not rely only on discretionary fiscal policy.   As noted in the introduction to this section, discretionary policy can suffer from 'policy lags' leading to counterintuitive effects, e.g., fiscal stimulus is implemented but its impact occurs to late just as the business cycle turns around and then over stimulates the upswing.   On the other hand,  automatic stabilizers are triggered by 'objective' changes in the economy and implemented automatically according to an existing legislation, e.g., in a downturn,  unemployment rises, employment insurance payments increase maintaining aggregate demand and on the upswing payments into the unemp0loyment insurance fund increase while outflows diminish.  Similarly in a downturn causes income to fall and marginal taxes decrease.  Welfare and other public programs automatically kick in during a downturn and decline in the upswing.  A flexible exchange rate similarly buffers domestic aggregate demand.  During the upswing of the business cycle Canadian prices, especially interest rates, start to rise.  Rising interest rate attracts foreign investment that requires the purchase of Canadian currency increasing the foreign exchange rate.   Canadian exports become more expensive on world markets reducing exports and thereby reducing aggregate demand.  On the other hand, during a down turn Canadian interest rates tend to fall and foreign investment declines as does foreign demand for the Canadian currency thereby reducing the foreign exchange rate.  This makes Canadian exports less expensive and they increase thereby boosting domestic aggregate demand.

iii - Short & Long Run Fiscal Policy

a) Aggregate Demand

Assuming price stability, an expansionary fiscal policy (an increase in government expenditure, an increase in transfers or a decrease in taxes) will push aggregate planned expenditure up by the change times the appropriate multiplier. This will lead to an increase in aggregate demand at the same price level and reflected in a shift to the right of the aggregate demand curve (P&B 4th Ed Fig. 26.12). Similarly, assuming price stability a contractionary fiscal policy involves a decrease in government expenditure, a decrease in transfers and/or an increase in taxes. This will lead to a decrease in aggregate demand at the same price level times the appropriate multiplier and reflected in a leftward shift of the aggregate demand curve.

b) At or Below Potential GDP

If the economy is below potential GDP then there is some unemployment. The rightward shift of the ADC will, however, intersect the ASC at a higher point. Thus some of the initial increase in AD will inevitably translate into a general price rise reducing the overall effect of an expansionary fiscal policy (P&B 4th Ed Fig. 26. 13). If the economy is at potential then all the effects of an expansionary fiscal policy must fail in that there is no increase in real GDP possible and the only change has been an increase in the price level.

c) Aggregate Supply

While traditionally Keynesian theory has focused almost exclusively on aggregate demand as a means of moderating the business cycle and foster economic growth and price stability, a logical extension leads to the supply-side. Taxes are treated as part of the price of factors of production by firms.  Accordingly, if taxes rise the cost of production goes up and the ASC shifts to the left. Similarly, if taxes fall then the ASC will shift to the right, in effect increasing potential GDP (P&B 4th Ed  Fig. 26.15).  Thus taxes have an effect on both AD and AS.  This is known as 'supply-side economics'.  While tax reductions may have a supply effect the fact is once taxes effectively reach zero this policy tools loses any effectiveness.

d) Deficit & Debt
- more like business
- balance sheet
- capital/operating and amortization
- trans-generational transfers