Fiscal policy aims to achieve objectives like full employment and price stability through instruments like government spending and taxation. While fiscal policy was once used actively to counter business cycle fluctuations, its effectiveness is limited by the difficulties in accurately predicting economic impacts and political interference. Additionally, persistent budget deficits can rapidly increase debt levels, raising sustainability concerns. Most countries now pursue more conservative fiscal policies focused on reducing debt burdens through surpluses rather than attempting discretionary fine-tuning of aggregate demand.

1. 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

2. MACROECONOMIC POLICY
Objectives of macro policy:
• full employment
• stable prices
• steady growth
• equitable distribution of income
• balance of payments equilibrium (medium term)

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

4. 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

5. 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)

6. 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

7. What is fiscal policy?
- govt’s 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
FISCAL POLICY

8. 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

9. Fiscal policy stance
Financing government spending:
G - T = borrowing + creation of high-powered money
G > T = deficit
T > G = surplus
- surpluses occur in booms; deficits in slumps
- budget deficit does not necessarily mean that fiscal
stance is expansionary; recessions cause deficits

10. 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?

11. 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

12. 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

13. 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

14. • 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)

15. 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

16. Reducing debt may have expansionary effects
• cut in G can lead to:
- lower interest rates
- more confidence in govt’s macro policy
- inflow of private FDI
• greater consumer / investor confidence

17. • 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’

18. 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)

19. 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

20. • 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)