Notes for Level I CFA® Program

R18 Monetary and Fiscal Policy

3.1. Roles and Objectives of Fiscal PolicyWatch Video Play

Primary objective: To help manage the economy through its influence on aggregate national output (real GDP).

Fiscal Policy and Aggregate Demand

Just like monetary policy, fiscal policy can be contractionary or expansionary.

An expansionary fiscal policy can take several forms:

  • Lower taxes
    • Cuts in personal income tax (This increases the disposable income).
    • Cuts in sales taxes (This lowers the prices).
    • Cuts in corporate taxes increase business profits (This means that corporates have more money to invest).
  • Higher government spending on social goods and infrastructure.

Contractionary fiscal policy: It is the opposite of expansionary fiscal policy. Higher taxes or lower government spending are examples of contractionary fiscal policy.

What are the Keynesian and Monetarist views on the effectiveness of fiscal policy?

Keynesian view: Government intervention is necessary in the form of fiscal policy to get an economy out of recession. They believe that the aggregate demand, employment and output increase with fiscal policy .

Monetarist view: Monetary policy is a more effective tool to tame inflation; monetarists advocate a steady, stable monetary policy. They believe that Fiscal policy only has a temporary effect.

Government Receipts and Expenditures in Major Economies

  • Exhibits 13 and 14 show government revenues and expenditures as a percentage of GDP for some of the major economies. As of 2008, for the U.S., government revenue as a per cent of GDP was 32.3%, while the government expenditure as a percent of GDP was 38.8%.
  • The possibility that fiscal policy can influence output can be used to stabilize an economy.
  • The budget deficit is the difference between government revenue and expenditure for a fixed period of time. Government revenue = tax revenues, net of transfer payments; government spending = interest paid on government debt.
  • An increase in budget surplus indicates a contractionary fiscal policy.
  • An increase in budget deficit indicates an expansionary fiscal policy.
  • Two fiscal policies to stabilize the economy include:
    • Automatic stabilizers: When the economy slows and unemployment rises, government spending on social insurance and unemployment benefits will rise. If the economy is at full employment, taxes collected will be high and there will be a budget surplus. These happen automatically without the intervention of policymakers, and the focus is primarily on aggregate demand. They help reduce the impact of a recession.
    • Discretionary fiscal policies: Changes in government spending or tax rates. In contrast to automatic stabilizers, this depends on the policy makers. The policies differ primarily with respect to timing.
  • A balanced budget is one where government spending is equal to government revenues.

Deficits and National Debt

Government deficit = Revenue – Expenses

Government deficit (national debt) is the accumulation of these deficits over time. Should we worry about national debt? There are two schools of thought.

We should not worry because:

  • The scale of the problem may be overstated because the debt is owed internally to fellow citizens.
  • A proportion of the money borrowed may have been used for capital investment projects or enhancing human capital. We are borrowing now to increase our productive capacity in the future.
  • Large fiscal deficits require tax changes which may actually reduce distortions caused by existing tax structures.
  • Deficits may have no net impact because the private sector may act to offset fiscal deficit by increasing saving in anticipation of future increased taxes. This is known as Ricardian equivalence.
    • The government funds its spending by either increasing taxes or borrowing. It is the future taxpayers who will service the government’s debt. So, it is the taxpayers who bear the burden in both cases. What matters is only the timing: now or later. According to Ricardian equivalence, if the government defers taxation, consumers anticipate higher taxes and the private sector will save enough today to pay for increased taxes in the future. This higher saving results in decreased private demand and increased government demand. The net effect is offsetting as government spending does not create demand stimulus.
  • If there is unemployment in an economy, then the debt is not diverting activity away from productive uses.

We should worry because:

  • High levels of debt to GDP may lead to higher tax rates in the search for higher tax revenues. This may lead to disincentives to economic activity.
  • If markets lose confidence in a government, then the central bank may have to print money to finance a government deficit. This may lead to inflation.
  • Government borrowing may divert private sector investment from taking place (this effect is called crowding out). If savings are limited and the demand for funds from the government is high, then it will lead to higher interest rates and lower private sector investment.