Category Archives: Fiscal Policy

Keynes v Monetarist – Powerpoint download

Currently covering Keynes vs Monetarist in the A2 course. Here is a powerpoint on the theory that I use for revision purposes. I have found that the graphs are particularly useful in explaining the theory. The powerpoint includes explanations of:

– C+I+G+(X-M)
– 45˚line
– Circular Flow and the Multiplier
– Diagrammatic Representation of Multiplier and Accelerator
– Quantity Theory of Money
– Demand for Money – Liquidity Preference
– Defaltionary and Inflationary Gap
– Extreme Monetarist and Extreme Keynesian
– Summary Table of “Keynesian and Monetarist”
– Essay Questions with suggested answers.

Hope it is of use – 45˚line shown. Click the link below to download the file.
Keynes v Monetarist Keynote

Economics of Coronavirus – mindmap

Three different shocks that are prevalent

Supply shock – will become more visible in the coming weeks as importers from China maybe unable to source adequate supply given widespread shutdowns across Chinese manufacturing.This loss of intermediate goods for production of final products cause a decline in revenue and consumer well-being. A good example of supply shocks were the oil crisis years of 1973 (oil prices up 400%) and 1979 (oil prices up 200%).

Demand shock – is already affecting consumer demand as travel slows, people avoid large gatherings, and consumers reduce discretionary spending. Already many sports fixtures have been cancelled which in turn hits revenue streams. With the uncertainty about job security demand in the consumer market will drop – cars, electronics, iPhones etc. Also tourism and airline industries are also exposed to the fall in demand.

Financial shock – although the supply and demand shocks will eventually subside, the global financial system is likely to have a longer-lasting impact. Long-term growth is the willingness of borrowers and lenders to invest and these decisions are influenced by: increased uncertainty regarding the global supply chain; a loss of confidence in the economy to withstand another attack; and a loss of confidence regarding the infrastructure for dealing with this and future crises.

Policy options

Monetary policy is limited to what it can do with interest rates so low. Even with lower interest rates this does not tackle the problem of coronavirus – cheaper access to money won’t suddenly improve the supply chain or mean that consumers will start to spend more of their income. The RBNZ (NZ Central Bank) could instruct trading banks to be more tolerant of economic conditions.

Fiscal policy will be a much more powerful weapon – the government can help households by expanding the social safety net – extending unemployment benefit. Also the guaranteeing of employment should layoffs occur. Tourism and airline industries are being hit particularly hard. Although more of a monetary phenomenon the ‘Helicopter Drop’ could a policy tool of the government. A lot of governments already have introduced ‘shock therapy’ and unleashed significant stimulus measures:

  • Hong Kong – giving away cash to population – equivalent NZ$2,120.
  • China – infrastructure projects and subsidising business to pay workers.
  • Japan – trillions of Yen to subsidising workers. Small firms get 0% interest on loans.
  • Italy – fiscal expansion and a debt moratorium including mortgages
  • US – congress nearing stimulus package
  • NZ – stimulus package industry based

Source: The Real Economy Blog

A2 Economics – Keynes 45˚ line

Just completed the Keynes 45˚ line (still in the CIE A2 syllabus) with my A2 class and find this graph useful to explain it. A popular multi-choice question and usually in one part of an essay. Make sure that you are aware of the following;

Common Errors:
1. C and S are NOT parallel
2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.
To Remember:
1. OA is autonomous consumption.
2. Any consumption up to C=Y must be financed.
3. At OX1 all income is spent
4. At OB consumption = BQ and saving= PQ
5. Equilibrium level of Y shown in 2 ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I – point D

Remember the following equilibriums:
2 sector – S=I
With Govt – S+T = I+G
With Govt and Trade – S+T+M = I+G+X

Coronavirus – impact on the NZ economy

Below is a link to a very good interview with Corin Dann and Don Brash this morning on National Radio’s ‘Morning Report’. Former Reserve Bank Governor Don Brash says that the major Central Banks need to act together and reduce interest rates to offset the impact of Covid-19. The Central Banks he refers to are: US Fed, Bank of England, Bank of Japan and the European Central Bank. Good discussion of the impact of the NZ dollar on trade and the fact that just the past month in New Zealand, the virus may have cost as much as $300 million in lost exports to China. Worth a listen

National Radio – Don Brash interview

Automatic stabilisers – Direct Stimulus Payments

It is unavoidable that recessions are part of the economic environment that we live in. In tackling the impact of recessions it has become apparent that one cannot solely rely on expansionary monetary policy of the central bank. Economic conditions have changed, as if an economy was to fall into recession in this low interest environment monetary policy options are far more limited than they were post the GFC. Add to this a higher debt level and you put further pressure on the banking system. A publication this year entitled “Recession Ready – Fiscal policies to stabilise the American economy.” (Published by the Hamilton Group – Washington Center for Equitable Growth) suggests that governments should assist in ensuring that the recovery phase is much quicker than it has been by ensuring confidence amongst businesses and households so they resume investing and spending again. They focus on antirecession programmes known as “automatic stabilisers.”

Automatic stabilisers are the automatic increases in revenues and decreases in expenditure in the government budget that occur when the economy strengthens, and the opposite changes that occur when the economy weakens.

Increase in GDP growth = the government will receive more tax revenues – people earn more and so pay more income tax. As it is assumed that unemployment decreases the amount of money spent on unemployment benefit decreases.

Reduction in GDP growth = lower incomes – people pay less tax. As unemployment increases the government spends more on unemployment benefits. This increase in benefit spending and lower tax collection helps to limit the fall in aggregate demand.

One of the chapters written by Claudia Sahm proposes a direct payment to individuals that would automatically be paid out early in a recession and then continue annually when the recession is severe. During a recession consumer spending (C) declines sharply – see graph – and as it makes up above 70% of most countries aggregate demand – C+I+G+(X-M) – this can lead to employment losses and reduced output. Consumers therefore are integral to boosting aggregate demand and direct stimulus payments to individuals should become part of the system of automatic stabilisers as additional income translates quickly into additional spending.

Trigger to start automatic stimulus payments.

The idea behind this is for direct payments to individuals after a 0.5% in the quarterly unemployment rate. If you look at each recession since 1970 the stimulus trigger of an increase in 0.5% unemployment meant that payments would have been triggered within three months of the start of the past six recessions (USA). But there are some concerns with using unemployment data:

  1. Unemployment rate tends to lag the business cycle as unemployment tends to peak after the recession ahas ended.
  2. The rise in unemployment doesn’t necessarily mean you are in recession – two consecutive quarters of negative GDP.

Lump sum v Tax cuts

There is an argument that a one-off lump sum payment is much effective in boosting spending than changes in income tax which would be spread fiscal stimulus throughout the year. Even if the Marginal Propensity to Consume (MPC) was the same for both lump sum and tax cuts it would not be until early in the next year that the full spending occurred under the tax cut option. The delay in spending from lump sum payments would be three months thus the overall stimulus boost would be both larger and more rapid – see graph below.

Final thought
Direct stimulus payments would quickly deliver extra income to millions of households at the start of a recession and maintain income support until the recession has subsided. This should generate more aggregate demand and thereby reducing the impact of the recessionary phase.

Source: “Recession Ready – Fiscal policies to stabilise the American economy.” (Published by the Hamilton Group – Washington Center for Equitable Growth)

AS Revision – Indirect Tax

The AS multiple-choice paper is coming up and here is this graphic to explain indirect taxes – a popular question. An indirect tax will have the following effects on the market:

Indirect Tax

• The supply curve shifts vertically upwards(effectively a shift to the left) by the amount of the tax(gf) per unit. The price increases but not by the full amount of the tax. This is because of the slopes of the demand and supply curves.
• The consumer surplus is reduced from acp to agb. The portion gbhp of the old consumer surplus is transferred to government in the form of tax.
• The producer surplus is reduced from pce to fde. The portion phdf of the old producer surplus is transferred to the government in the form of tax.
• The market is no longer able to reach equilibrium, and there is a loss of allocative efficiency resulting in the deadweight lost shown by the area bcd. This represents a loss of both consumer surplus bhc and the producer surplus hcd that is removed from the market. The deadweight loss also represents a loss of welfare to an individual or group where that loss is not offset by a welfare gain to some other individual or group.

AS and A2 Macroeconomics: Internal and External Balances

In explaining the differences between internal and external balances I came across an old textbook that I used at University – Economics by David Begg. It was described as ‘The Student’s Bible” by BBC Radio 4 and I certainly do refer back to it quite regularly. Part 4 on macroeconomics has an informative diagram that shows the impact of booms and recessions on the internal and external balances.

Internal Balance – when Aggregate Demand equals Aggregate Supply (potential output). And there is full employment in the labour market. With sluggish wage and price adjustment, lower AD causes a recession. Only when AD returns to potential output is internal balance restored.

External Balance – this refers to the Current Account balance. The country is neither underspending nor overspending its foreign income. For a floating exchange rate, the total balance of payments is always zero. Since the balance of payments is the sum of the current, capital, and financial accounts, saying the current account is in balance then also implies that the sum of the capital and financial accounts are in balance.

In the diagram right the point of internal and external balance is the intersection of the two axes, with neither boom nor slump, and with neither a current account surplus nor a deficit.

The top left-hand quadrant shows a combination of a domestic slump and a current account surplus. This can be caused by a rise in desired savings or by an adoption of a tight fiscal policy and monetary policy. These reduce AD which cause both a domestic slump and a reduction in imports.

The bottom left-hand corner shows a higher real exchange rate, which makes exports less competitive, reduces export demand and raises import demand. The fall in net exports induces both a current account deficit and lower AD, leading to a domestic slump.

In a downturn a more expansionary fiscal and monetary policy can hasten the return to full employment eg. Quantitative easing, tax cuts, lower interest rates. However one could say that today it doesn’t seem to be that effective.

A2 Revision – Fiscal Policy

With the exam season just about to start in New Zealand I thought it appropriate to do some revision blog posts. In the CIE A2 paper there is always a macro policy question and it usually focuses on the conflicts between the different objectives. Below is a mindmap on fiscal policy that might be useful. Fiscal Policy involves the use of Government Spending and Taxation in order to influence the level of economic activity. The Government receives money through Taxation (T) and spends money through Government spending (G).

  • A budget deficit occurs when G > T
  • A budget surplus occurs when T > G

Should Central Banks still be independent?

Video from CNBC looking at why central banks became independent and if it still should be the case – very informative and they use the Phillips Curve in their explanation. WIth the ongoing inflation problems in the 1970’s and 80’s it was thought that giving central banks independence of government control should be implemented. It was argued that policy makers would struggle to convince the public they were serious about containing inflation if politicians retained a say on setting interest rates. In 1989 New Zealand become the first country to introduce an independent bank with the 1989 – Reserve Bank Act. The mandate was to keep inflation between 0-2% but later changed to 1-3%.

With the GFC in 2008 it was central banks who slashed interest rates and implemented several rounds of quantitative easing to stimulate demand. However the GFC could have been prevented if central banks intervened to stop the biggest asset-bubble in history instead of focusing purely on keeping inflation low. Furthermore the European Central Bank were slow to act and the recovery was stymied. The fact that Germany is under the threat of deflation means that the ECB have cut interest into negative territory and are relaunch another round of quantitative easing – they are running out of options. Economists are focusing on fiscal stimulus – tax cuts and government spending. Therefore monetary and fiscal policy should be working together. According to Larry Elliott of The Guardian. central bank independence is a product of the neoliberal Chicago school of economics and aims to advance neoliberal interests. More specifically, workers like high employment because in those circumstances it is easier to bid up pay.

Hyperinflation – can be controlled with a different government.

Venezuela has been in the news for sometime with its economy spiralling out of control with the inflation rate last year at 100,000% – doubling roughly once a month. The occurrence of hyperinflation in economies has become more common with governments now printing money rather than that money being backed by the amount of gold that they held – gold standard. Because the gold supply is quite inelastic, being on the gold standard would theoretically stop government overspending and keep inflation under control. The country effectively abandoned the gold standard in 1933, and completely severed the link between the dollar and gold in 1971 – this was around the time of the Vietnam War.

The more recent hyperinflation in Zimbabwe, Bolivia, Argentina etc have come about through government’s not been able to control the printing presses and succumbing to the desire to stay in power at the expense of crippling the economy. Huge fiscal deficits and excessive borrowing are the common denominator here – see flow chart below:

Hyperinflation usually happens amongst chaotic domestic conditions, whether social unrest or that country being involved in conflict – e.g. post war Germany. However as reported by The Economist hyperinflation can occur under more mundane circumstances. For instance in Bolivia’s inflation reached 60,000% which was started by a commodity boom which allowed them to borrow heavily from overseas but once resource prices tumbled there was a significant reduction in government revenue. The  government under Hugo Banzer increased spending to satisfy the voters who supported them in the election and this created further inflationary pressure. In a way this is similar to the Venezuela experience with high oil prices generating significant revenue for the government but once the oil prices fell the printing presses started to work overtime. And once inflation starts to accelerate Inflationary expectations kick in and then it becomes very difficult to control. However these inflationary expectations could reflect the lack of seriousness of government policy to rectify the problem as a change of government which is focused on prices can end hyperinflation in weeks. This reflects the trust in the incoming regime and was true of Bolivia (see video below).  Here the incoming government under Gonzalo (Goni) Sánchez de Lozada were serious about the ravages of inflation and to deal with it  didn’t use highly sophisticated economic theory.  See below:

  • Government spending was slashed
  • Price controls were scrapped
  • Import tariffs were cut
  • Government budgets were balanced.
  • No borrowing from the Central Bank

As Jeff Sachs – advisor to the Bolivian government –  said:

“All this gradualist stuff just doesn’t work. When it really gets out of control you’ve got to stop it, like in medicine. You’ve got to take some radical steps; otherwise your patient is going to die.”

Sources:

The Economist – February 2nd 2019

Commanding Heights – PBS Video