Fiscal Policy

Question 1

Public finances

Answer 1

The entirety of expenditure and revenue operations of the government.

Question 2

Government budget

Answer 2

A document that specifies the origin and volume of both revenues and intended spending over a certain horizon

Question 3

The fiscal (or budgetary) policy essentially serves the stabilization function. Explain

Answer 3

The government manipulates its expenditure and revenue with the aim of influencing the level and dynamics of economic activity. Any measure which changes the level timing or composition of public expenditure and taxation.

–> Stabilising business cycles, promoting potential output level

Question 4

Fiscal Policy: Automatic stabilisers

Answer 4

The mechanism whereby the prevailing system of public finances automatically alleviates fluctuations, without active intervention by the government

Question 5

Fiscal Policy: Discretionary measures

Answer 5

Public expenditure and taxation are actively manipulated by the government in order to dampen fluctuations in economic activity

Question 6

The fiscal policy stance:

What are the two possible stances of fiscal policy?

Answer 6

Tight/restrictive/contractionary: often seen as fiscal consolidation

Loose/expansionary: higher spending and lower taxes, fiscal expansion

Question 7

What do interest payments on the national debt tell us about fiscal policy?

Answer 7

Interest payments on the national debt are predetermined by the size of previous deficits, and hence the size of the debt outstanding. The government cannot influence these payments in the short term. Hence, they do not reflect current policies.

Question 8

Discretionary measures and Cyclical Fluctuations

Answer 8

Without discretionary measures cyclical fluctuations of the economy cause cyclical fluctuations of tax revenues and of some types of government spending (e.g., unemployment insurance benefits), which alters the government budget situation. These are not considered as discretionary fiscal policy changes.

Question 9

The effectiveness of automatic stabilizers: How do they work? (Disposable income channel)

Answer 9

The tax/benefit system reduces fluctuations in disposable income, thereby stabilizing aggregate demand.

Question 10

The effectiveness of automatic stabilizers: How do they work? (Marginal incentives channel)

Answer 10

With a progressive tax system, the tax rate rises in booms and falls in recessions, encouraging intertemporal substitution of work effort away from booms and into recessions.

Question 11

The effectiveness of automatic stabilizers: How do they work? (Redistribution channel)

Answer 11

If those that receive funds have higher propensities to spend than those who give funds, aggregate consumption and demand will rise with redistribution.

Question 12

Crowding out

Answer 12

If the government finances a expenditure or tax reduction by borowwing

Question 13

The effectiveness of fiscal policy

Answer 13

Delays in decision-making and crowding out may dampen the effectiveness

Question 14

What is “Crowding Out”?

Answer 14

If the government finances an expenditure or tax reduction by borrowing, which may lead to higher interest rates. This could result in a reduced interest by other spending components (business investment, house building, etc.) so that the overall effect on aggregate demand is less than the original fiscal expansion

Question 15

What is “Export Crowding Out”?

Answer 15

In case the economy operates under a floating exchange rate regime, an expansionary fiscal policy may trigger an appreciation of the domestic currency as a consequence of increasing interest rates. The latter indeed makes investments in financial assets issued in the domestic currency more attractive, thus creating capital inflows. The accompanying appreciation erodes the international competitiveness of domestic firms, which in turn adversely affects exports.

For this mechanism to work, capital flows must be
sufficiently sensitive to interest rates.

Question 16

Fiscal policy and fixed exchange rates

Answer 16

Fiscal policy will generally gain strength because the capital inflows will then swell the domestic money supply, providing an additional monetary stimulus.

For this mechanism to work, capital flows must be
sufficiently sensitive to interest rates.

Question 17

Expansionary fiscal contraction

Answer 17

Government savings not only reduce the expected future fiscal pressure, but also increase consumer and producer confidence.

Consumers will therefore save less and consume more, and producers will produce and invest more. The initial restrictive policy can thus ultimately have expansionary effects.

Question 18

The effectiveness of fiscal policy: The Ricardian equivalence theorem

Answer 18

In the case of a debt-financed increase in public spending, economic agents anticipate the future taxes needed to finance the interest charges and repayment of the public debt. Rational consumers will discount these future taxes, leading to a reduction in their current consumption and an increase in their savings.

Empirical research however gives little support to this ‘tax discounting’ hypothesis.

Question 19

Fiscal Multiplier

Answer 19

This measures the change in economic activity as a result of measures that fall within the scope of fiscal policy.

In other words, by how much does real GDP increase (decrease) if the government increases (decreases) the budget deficit by one percentage point of GDP.

Question 20

Self-defeating austerity

Answer 20

In extreme cases, fiscal consolidation can be self defeating.

The question was whether excessive austerity will not burden the economic
malaise to such an extent that it becomes ineffective or even counterproductive

Question 21

The consensus is that the effects of fiscal consolidation on economic growth are greatest when:

Answer 21

• The economy is performing below its potential (a negative ‘output gap’)
• Households and firms are deleveraging
• Trading partners are also reducing government spending or raising taxes.

Question 22

Is Government Debt acceptable?

Answer 22

Government debt is acceptable if it increases the productive capacity of the economy and if the return from debt-increasing measures (e.g., investment in infrastructure and education) exceeds the interest burden of the debt

Question 23

What is the “Intergenerational Neutrality

Criterion”?

Answer 23

By creating public debt, one increases the disposable income of the current generation to the detriment of future generations. According to the criterion, each generation’s net contribution to the debt must be equal.

Question 24

The burden of public debt: Distribution effects

Answer 24

• From taxpayers to interest recipients (after all, additional taxes are required to pay the interest)
• From future generations to the current generation (insofar as additional taxes will be required in the future to make the repayment of the principal and interest possible)

Question 25

The burden of public debt: The Cuckoo Effect

Answer 25

A sharply rising debt can in itself cause interest rates to rise, which in turn acts as a brake on private investment

Question 26

General Budget and Cyclical Fluctuations

Answer 26

A higher fiscal deficit cannot always be attributed to a loosening of the fiscal stance, but may simply reflect that the economy is moving into a trough. In other words, the general budget tends to be pro-cyclical.

Question 27

Why is fiscal policy not always a suitable measure on the short-term?

Answer 27

There are many delays that occur in decision-making

Example: lags in recognition, approvement by parliament

Question 28

Why are taxes more suitable on the short-term than expenditures?

Answer 28

Taxes are more easily manipulated

Question 29

Ricardian equivalence theorem: what is the effect of debt-ratio on the effectivenss of fiscal policy?

Answer 29

If debt-ratio exceeds a critical level, economic agents will anticipate future taxes whenever a debt-financed increase in public spending occurs.

They will increase savings and decrease consumption.

Question 30

What is the “Intergenerational neutrality

criterion”?

Answer 30

According to the criterion, each

generation’s net contribution to the debt must be equal.

Question 31

What is the “Snowball effect”?

Answer 31

It is a mechanism of automatic accumulation of debt: even in the absence of a primary deficit, the debt ratio
increases when the interest rate on outstanding government debt exceeds nominal
GDP growth.

Question 32

What are “stock flow adjustments”?

Answer 32

Exogenous debt determinants, also known as stock flow adjustments, affect the debt directly, not through the budget balance, and typically involve the acquisition or disposal of assets by the government.

Question 33

What are “contingent liabilities”

Answer 33

Apart from the formal debt, the government often also guarantees risks taken by others
or enters into commitments that will not yet lead to expenditure in the current budget year

Question 34

What is the ‘corrective arm’ from the Stability and Growth Pact?

Answer 34

The corrective arm ensures that EU governments adopt appropriate policy response to correct excessive deficits and debts.

Question 35

What is the ‘preventive arm’ from the Stability and Growth Pact?

Answer 35

The preventive arm supports EU governments in achieving their commitments on sound fiscal policies