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(d)
Policy
While the Great
Depression of the 1930s was the most severe and long lasting, it was but a
single link the long chain of the business cycle - boom/bust, no happy medium,
much pleasure followed by much pain to the general public. This dragon's tail
stretches back beyond 1815 and the end of the Napoleonic War and the public
policy beginnings of
Classical and
Neoclassical Schools Economic History and the
overthrow of the
Mercantilist public policy mentality.
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 mitigate the
pleasure and pain of the business cycle, to stabilize the economy. And linked to
moderating the business cycle is to do so while, at the same time, foster 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.
(i)
Fiscal Policy Multipliers
But
how 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 very short-run and a constant price level. These
are:
(i) Government Expenditure Multiplier
(ii) Autonomous Tax Multiplier
(iii) Balanced Budget Multiplier
Government Expenditure Multiplier (GEM)
The GEM depends on the marginal
propensity to consumer (P&B 4th Ed Fig. 26.8;
7th Ed not displayed). 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.
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.
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;
7th Ed not displayed). The size of the ATM depends on the slope of the AEC and, hence, of the MPC.
The ATM is equal to the MPC divided by 1 minus the slope of the AEC. The ATM is
always negative because it always decreases AE. ATM = -b/1-b =
∆Y/∆T.
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.
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
(b) Short
& Long Run Fiscal Policy
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;
7th Ed not displayed). 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.
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;
7th Ed not displayed). 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.
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; 7th Ed not displayed). Thus taxes have an effect on both AD and AS.
(v)
Cyclical & Structural Surpluses and Deficits
(P&B
4th Ed Fig. 26.11;
7th Ed not displayed)
(vi) Deficit & Debt
- more like business
- balance sheet
- capital/operating and amortization
- trans-generational transfers
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