1. Fiscal Policy and the Cycle

2. Time Lags Regarding Monetary and Fiscal Policy stabilisation policy Describes both monetary and fiscal policy, the goals of which are to smooth out fluctuations in output and employment and to keep prices as stable as possible. time lags Delays in the economy’s response to stabilization policies. Two Possible Time Paths for GDP Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A.

3. Time Lags Regarding Monetary and Fiscal Policy Stabilisation Attempts to stabilise the economy can prove destabilising because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. Hence, the policy pushes the economy to points E’ and F’ (instead of points E and F). Income varies more widely than it would have if no policy had been implemented.

4. Time Lags Regarding Monetary and Fiscal Policy Recognition Lags recognition lag The time it takes for policy makers to recognize the existence of a boom or a slump. Implementation Lags implementation lag The time it takes to put the desired policy into effect once economists and policy makers recognize that the economy is in a boom or a slump. Response Lags response lag The time that it takes for the economy to adjust to the new conditions after a new policy is implemented; the lag that occurs because of the operation of the economy itself.

5. Time Lags Regarding Monetary and Fiscal Policy Response Lags Response Lags for Fiscal Policy There is a lag between the time a fiscal policy action is initiated and the time the full change in GDP is realised. Until individuals or firms can revise their spending plans, extra government spending does not stimulate extra private spending. Response Lags for Monetary Policy Monetary policy works by changing interest rates, which then change planned investment. The response of consumption and investment to interest rate changes takes time.

6. Time Lags Regarding Monetary and Fiscal Policy Summary Stabilisation is not easily achieved even if there are no surprise asset-price changes. It takes time for policy makers to recognize the existence of a problem, more time for them to implement a solution, and yet more time for firms and households to respond to the stabilization policies taken. Monetary policy can be adjusted more quickly and easily than taxes or government spending, making it a useful instrument in stabilising the economy. But because the economy’s response to monetary changes is probably slower than its response to changes in fiscal policy, tax and spending changes may also play a useful role in macroeconomic management.

7. Government Deficit Issues If a government is trying to stimulate the economy through tax cuts or spending increases, this, other things being equal, will increase the government deficit. One thus expects deficits in recessions—cyclical deficits. These deficits are temporary and do not impose any long-run problems, especially if modest surpluses are run when there is full employment. If, however, at full employment the deficit—the structural deficit—is still large, this can have negative long-run consequences. Negative asset-market (stocks and share price) reactions may affect the long-run deficit strategy of the government. If there is a structural deficit problem, policy makers may not have the freedom to lower taxes or raise spending to mitigate a downturn.

8. Government Deficit Issues Deficit Targeting HM Government is aiming for a zero deficit by fiscal year 2018-19. However, deficit reduction targets in previous years have not been met. 1. It is not always possible to cut G – welfare payments for example may be increasing, or other elements of cyclical expenditure. 2. The size of the deficits critically affected by tax revenues. If unemployment rises, tax revenues fall. 3. The structural change in employment affects tax revenue. In the UK there has been a shift to low-paid jobs and zero hour contracts. More people are also self-employed (and this produces a lag in tax revenues as income is not declared till the end of the tax year). 4. For supply-side reasons the Government has raised the level of tax free income to £10,600 (partly to increase the incentive to work at the lower end). But this is a tax cut for everyone. An estimated 3m workers pay no tax at all.

9. Government Deficit Issues Deficit Targeting automatic stabilisers Revenue and expenditure items in the budget that automatically change with the economy in such a way as to stabilize GDP. automatic destabilisers Revenue and expenditure items in the budget that automatically change with the economy in such a way as to destabilise GDP.

10. Government Deficit Issues Deficit Targeting Deficit Targeting as an Automatic Destabiliser Deficit targeting changes the way the economy responds to negative demand shocks because it does not allow the deficit to increase. The result is a smaller deficit but a larger decline in income than would have otherwise occurred.

11. Government Deficit Issues Deficit Targeting Deficit targeting has undesirable macroeconomic consequences. It requires cuts in spending or increases in taxes at times when the economy is already experiencing problems. Locking in spending cuts during periods of negative demand shocks is not a good way to manage the economy. Policy makers may have to devise other methods to control growing structural deficits.

12. Key terms • automatic destabilisers • automatic stabilisers • recognition lag • response lag • stabilisation policy • time lags