wk5- fiscal policy

• The budget- a government's budget is an annual statement of projected outlays and revenues during the next year with laws and regulations that support
• Fiscal policy- the use of a government's budget to achieve macroeconomic objectives such as full employment, sustained economic growth and price level stability
• An expansionary fiscal policy- policy of increased government expenditure and/or tax cuts designed to boost economic activity
• A contractionary / tight /deflationary fiscal policy- a policy of decreased government expenditure and/or tax rises designed to lower economic activity
• Roles of fiscal policy- may be used to affect aggregate demand to prevent the occurrence of fundamental disequilibrium in economy, stabilisation policies. Or to influence aggregate supply
• A neutral fiscal policy- a policy neither designed to boost or lower economic activity
• The primary fiscal deficit /surplus- deficit or surplus less interest payable on national debt
• Automatic fiscal policy- change in policy triggered by state of economy

  Discretionary fiscal policy- policy action initiated by government aimed at influencing levels of economic activity
• Automatic (built in) stabilisers- mechanisms that stabilise real GDP without explicit action by government (income taxes and transfer payments), reduce size of multiplier, reduce both upward and downward movements of national income. 
• Problems with automatic stabilisers- Adverse supply side effects, high tax rates may discourage effort and initiative, high unemployment benefits may increase equilibrium unemployment, high income related benefits may create a poverty trap. Problem of fiscal drag can act as a drag on expansion if stabilising hen in deep recession as reduce size of multiplier so reduce magnitude of recovery
• How a government finances fiscal debt- by issuing treasury bonds for sale on the financial market, a treasury bond is a long term (greater than a year) debt instrument that promises to pay the buyer a series of cash flows known as coupon payments and then the principal upon maturity. Government must decide the amount of years this affects the maturity of the national debt.
• Fiscal policy is distinct from monetary policy- monetary policy is about short term rate of interest and growth of money supply, such as the sales and purchases of treasury bills. However treasury bond sales are long term financial instruments and their sale does not normally affect money supply
• What the government can do when facing fiscal debt- finance by bond sales (increases national debt and imply higher debt service payments in future), increase taxes (reduces fiscal deficit but slows economic activity, can be politically unpopular), cut government expenditure (reduces fiscal debt, slows down economic activity, politically unpopular, issue of what to cut), sell state assets, print money (implies rise in inflation)
• Fiscal multiplier- magnification of change in government expenditure on goods and services on equilibrium aggregate expenditure and real gdp. This exists because an increase in government expenditure increases aggregate income, induces a further increase in consumption expenditure
• Crowding out- occurs when increased government expenditure leads to lower private sector consumption and investment, less of a boost to aggregate demand
• Borrowing money can push up interest rate, raising taxes hits consumption and investment, upsetting the financial markets, the barro effect (economic agents will conclude that higher fiscal deficits today mean larger higher taxes in future so save ore today), adverse supply side effects, interest rate rises may lead to an appreciating currency hitting exports
• Problems with fiscal policy in practice- governments do not know exactly where the economy is in the business cycle, do not know size of fiscal multiplier, extent of crowding is uncertain, may lead to deterioration of current account, may lead to a rise in inflation rates, can be slow to get approval
• Tolerable tax burden- a tax burden that an average voter might be willing to tolerate acts as a constraint on public spending

  Inspection effect- effect of wars shining a light on issues where society believes more government intervention is needed
• Assume money supply is an endogenous dependent demand for money. Higher money demand will result in higher interest rates and higher levels of money supply

  Because banks accommodate the increase in demand for credit, depositors switch to less liquid deposit, inflows of funds from abroad
• Value of money balances that the public wishes to hold, relates to a stock of money and measured in uk as billions of pounds, holding money involves a loss of the rate of interest that could of been earnt 

  The demand to hold money is a demand to hold real money balances
• Keynes identified 3 motives for holding money- money balances are held despite the opportunity cost of bond interest foregone because of the transactions, precautionary and speculative motives
• Transactions demanded 

  Derived from the role of money as a medium of exchange and provider of liquidity 

  Mt=f(Y,P,W)

  Mt is transaction demand, Y level of real income, P is aggregate price level and W is wealth 
• Speculative demand 

  Derived from role of money as a safe asset, money balances held for this purpose are called idle balances 

  Nominal demand for money varies positively with real income, positively with the price level, positively with wealth and negatively with nominal rate of interest
• Precautionary demand 

  We live in an uncertain world and there will be a residual demand to hold money. This is an excess demand to hold money for unforeseen contingencies

  If we ignore the precautionary demand to hold money, can say the nominal money demand Md is made up of the transactions and speculative demand 

  Md= Mt + Msp
• Equilibrium 

  In money market where supply of money is equal to be demand, achieved through changes in nominal interest

  In foreign exchange market is where demand and supply of currency is equal 
• Simplifications in analysis 

  .Assumed price level is fixed, expansion or contraction of aggregate demand influences level of output but not prices

  .Ignored impact of associated income changes on money demand function and business, consumer and financial market expectations 

  .Ignored exchange rate and open economy effects 

  .ignored effects of interest rate changes on consumer expenditure and assets like equities, property market and associated wealth effects 
• Impact of interest rate changes on target variables

  Old monetarist rule of thumb was that a change in monetary policy took one year to affect output and two years to affect prices 

  The Bank of England's own forecasting model shows similar timelags, peak effect on gdp after 5 quarters, peak effect on inflation after 9 quarters. Estimates a 1% change in short term interest rate has about a 0.3% point effect on gdp and inflation rate 
• Determinants of money demand

  • Price level
  • Interest rate
  • Real GDP
  • Wealth
  • Financial innovation
• Price level

  A rise increases nominal quantity of money demand in proportion
• Interest rate

  The opportunity cost of holding wealth in the form of money rather than interest-bearing asset. A rise in the interest rate decreases the quantity of money that people plan to hold.
• Real GDP

  A rise increases the volume expenditure which increases the quantity of real money that people plan to hold
• Wealth

  A rise leads to a rise in spending hence increase of quantity of money that people plan to hold
• Financial innovation

  Technological change, arrival of new financial products. If lowers the cost of switching between money and interest bearing assets decreases the quantity of money that people plan to hold.