Factors That Governing Fiscal Policy - Assignment Example

Part (a) Factors that governing fiscal policy: There are a number of factors that govern fiscal policies in the UK; these include two objectives, five principles and two rules. There are two objectives governing fiscal policies and they are medium term and short term objective. a. Objective: I. Short term objective The short term objective is to ensure that fiscal policies support monetary policies and also to apply fiscal policies in order to allow the economies to self adjust. (HM Treasury (2009)) II. Medium term objective The medium term objective is to ensure that fiscal policies have a fair impact across generation. This means that spending current spending should have negative impacts on future generation. (HM Treasury (2009)) b. Principle: i. Stability: Fiscal policies should be aimed at achieving stability ii. Transparency: Transparency in the implementation of fiscal policies and also in the publication of accounts iii. Efficiency: Efficiency in the implementation of policies iv. Fairness: Fairness across generations current spending should not negatively impact future generation v. Responsibility: Proper formulation and implementation of fiscal policies (HM Treasury (2009)) c. Rules: There are two rules governing fiscal policies in the economy and they include the golden rule and sustainable investment. Golden rule: The golden rule states that public borrowing should be meant for investment and not for spending. (HM Treasury (2009)) Sustainable investment: The sustainable investment rule states that net debt as a percentage of GDP should be below 40%. (HM Treasury (2009)) UK fiscal policy since 1980: During the post war era public debts as a percentage of GDP reached over 200% percentage of GDP, the impact of spending in the war declined over time and in 1947 deficits as a percentage of GDP was approximately 50%, war spending did not meet the current fairness principle and also did not meet the sustainable investment level and this means that public deficits exceeded the 40% of GDP. (Clark, (2006)) In the early 80's the economy experienced a recession and this was followed by an economic boom in the late 80's, the fiscal policy measures were aimed at imposing cyclical adjustment, the fiscal policy for the recession of early 80's was contractionary fiscal policy and this led to a reduction in public sector deficits. In the economic boom of the late 80's fiscal policies were expansionary was recorded following and surpluses of the late 80's were turned into deficits in 1990. Expansionary fiscal policies were used in the following years and this saw a further increase in deficit whereby a 5.5% of GDP deficit was recorded for the year 1992 and 1995, this increase in borrowing led to an increase in deficits whereby it reached 7.8% of GDP in the year 1993, there was a further decline in borrowing and in 1998 the economy recorded a surplus reaching 2.0% of GDP in the year 2000. From the above it is evident that in 1997 and 1998 and also for the year 2006 and 2007 sound policies were implemented and this was a reduction in borrowing leading to better economic growth and performance. (Clark, (2006)) Part (b) Data plot for the years 1996 to 2006: (i) The public sector net borrowing The chart below summarises the public sector net borrowing for the year 1996 to 2006, data was retrieved from National Statistics (2009) From the above chart it is evident that in 1996 to 1997 public borrowing was negative, however public sector borrowing increased and for the year 1998 to 2001 public sector net borrowing was positive, this was followed by a decline in borrowing in 2002 to 2006 the public sector net borrowing was negative. This means that there has been cycles of increase and decline in the public sector net borrowing, this also shows that there are period of deficits and surpluses from the chart above meaning that in some years the government spending was less than income resulting into surpluses, while in the other period spending was greater than income resulting into borrowing. From our above discussion it is evident that in 1997 to 1998 sound policies were used, this is shown by the above chart where borrowing in these periods was negative meaning there were surpluses and the government did not borrow. It is also evident that in 2006 there public borrowing was negative. (ii) The budget surplus/deficit The chart below summarises the public sector deficit and surplus over the years from 1996 to 2006, data retrieved from National Statistics (2009) From the chart above it is evident that there have periods of deficits and surplus, deficits occur when spending is greater than income and surplus occur when spending is less than income. From the chart it is evident that there was a surplus in the year 1996 and 1997, a deficit in the year 1998 to 2001 and a surplus in the year 2002 to 2006. This shows a cycle that shows periods of deficits and surpluses. (iii) Output gaps/growth The chart below summarises the output gap as a percentage of potential GDP for the year 1996 to 2006, data retrieved from IMF (2008) From the above chart it is evident that in1999, 1996,2002, 2003 and 2005 the output gap was negative and this shows that the actual GDP in these years was less than potential GDP, for the other years the output gap is positive meaning that actual GDP was greater than potential GDP. Discussion: When government spending exceeds income from tax and other revenue source then there is a deficit, when a deficit occurs then the government is likely to borrow money from the public in order to finance expenditure. When government spending is less than revenue then there is surplus. The following diagram summarises government spending and surpluses for the period 1996 to 2006: From the above chart it is evident that periods of budget deficits are accompanied by higher public borrowing and periods of budget surplus are periods of negative public borrowing. Government borrowing has an effect on the economy whereby high borrowing increases aggregate demand stimulating activities in the economy, low borrowing on the other hand shows repayments of debts and also depicts that there will be low aggregate demand, government spending is inflationary and the output gap depicts the effectiveness of government spending on the economy. Spending and output gap: The following chart shows the relationship between output gap and the public sector deficit: From the above chart it is evident that in the period of deficit example 1998 to 2001 which means that the government was spending more than its revenue the output gap was positive, the positive output shows that the actual output is greater than potential output, on the other hand in period of surpluses the output gap is relatively low and negative, this means that the economy actual output is less than the potential GDP, (HM Treasury (2007)) for this reason therefore it is evident that an increase in government spending will result into an increase in aggregate demand increasing the output level. The AS/AD model: The AD/AS model in this case helps determine the relationship between fiscal policies and their effect on the inflation, demand and output level in the economy, According to the AS/AD model fiscal policies in a recession require an expansionary fiscal policy in order to increase aggregate demand, (Tobin (1975)) using the AS/ AD model in economic boom fiscal policies should be contractionary aimed at reducing aggregate demand, from the above it is evident that public deficit in the year 1998 to 2001 lead to an increase in the output gap meaning that there was an increase in actual output following government spending. On the other hand public sector surplus in the year 2002 to 2006 led to a decline in the output gap and this means that the decline in government spending led to a decline in actual output whereby actual output was less than potential output. Part (c): Difficulties in determining impacts of fiscal policy: The full impact of fiscal policies is difficult to determine, however implementation of these policies have their expected outcomes but it is still difficult to determine the full impact due to a number of reasons ranging from expectations, time lags, unknown variables and existence of other policies that may be implemented after. One of the major problems associated with determining the impact of fiscal policies on an economy is that even without changes in fiscal policies the changes in economic performance will affect government revenue, the impact of policies in the economy are also difficult to determine due to the occurrence of unanticipated inflation whereby government expenditure impact on inflation may not be determined when there is a supply shocks. Changes in output may be attributed to other factors and not changes in fiscal policies, for example an economy may be experiencing a boom and expansionary policies are implemented, on the other and the economy may be experiencing a mild recession and a contractionary fiscal policy is implemented, therefore it would be very difficult to differentiate the impact of the mild recession on output from the impact as a result of fiscal policies. In a recession or a boom policy makers have 2 alternative, one alternative is to act immediately and resolve the problem, the other option is to wait for the economy to undergo the recession or boom and only act to speed up the recovery process, in this case therefore it is evident that an economy automatically adjusts itself and therefore these self adjustment may affect accurate measures of changes in output and inflation resulting from the implementation of policies, for example in a recession expansionary fiscal policies will be implemented and despite full knowledge of inflation and output levels it will be still difficult to determine the effect of these policies because the economy will self adjust aided by the fiscal policies. (Scott (1996)) There are a number of limitations to the AS/AD model, some of these limitations include the fact that for the AS/AD model there is need to determine inflation levels, the level of inflation in an economy may be uncertain due to inflation expectations, (Meltzer (1998)) in order to determine the effect of increase or decline in spending on inflation it is important to determine the expected inflation in the economy which may be difficult to determine, therefore the effect of spending on inflation may be difficult to determine. Another problem that may limit the determination of the impact of fiscal policies is time lag, policy makers may not determine the time period an economy takes to adjust to changes in the policies, from the above discussion it is evident that the impact of an expansionary monetary policy may take time and therefore it would be difficult to determine the impact of policy change. An example from the above discussion is the case where the deficits after the war spread over a number of years. (Keynes (1973)) The other problem is the fiscal policies may be dependent on monetary policies and therefore changes in fiscal policies may lead to changes in monetary policies, another problem is the use of mixed policies whereby expansionary fiscal policies may be implemented and at the same time expansionary or contractionary monetary policies implemented and therefore it would be difficult to determine the effect of a change in the fiscal policy on the economy for example the effect on inflation, unemployment and output. (Scott (1996)) When implementing fiscal policies the problem of uncertainty may arise, for example the current GDP level or the level of output may be uncertain and therefore after implementation of the fiscal policies it may be difficult to determine the impact of the policy on the level of output, potential GDP and inflation level in the economy may also be unknown and therefore the impact of policies on the rate of inflation and output may not be determined. References: Clark, T. and Dilnot, A. (2006) Measuring the UK Fiscal Stance since the Second World War, viewed 24th March, http://www.ifs.org.uk/bns/bn26.pdf HM Treasury (2007) Fiscal policies: lessons from the last economic cycle, viewed 24th March, http://www.hm-treasury.gov.uk/d/lessons_from_the_last_economic_cycle.pdf HM Treasury (2009) Principles, Objectives and Rules governing fiscal policies, viewed 24th March, http://www.hm-treasury.gov.uk/ukecon_fisc_index.htm IMF (2008) UK potential GDP and Output gap, viewed 24th March, http://www.imf.org/external/pubs/ft/weo/2008/02/weodata/weorept.aspxsy=1996&ey=2006&scsm=1&ssd=1&sort=country&ds=.&br=1&c=112&s=NGAP_NPGDP&grp=0&a=&pr1.x=31&pr1.y=13#download Keynes, M. (1973) The General Theory of Employment, Interest and Money, Macmillan publishers, London Meltzer, H. (1998) Keynes Monetary Theory; A different approach, Cambridge university press, Cambridge National Statistics (2009) UK Budget Deficits and Public Sector Net borrowing, Viewed 24th March, http://www.statistics.gov.uk/statbase/tsdtimezone.asp Scott, P. (1996) "Keynesian theory and the Aggregate Supply Aggregate Demand framework", Eastern Economic Journal, Volume 22, page 313 to 331 Tobin, J. (1975) "Keynesian Models of Recession and Depression" American Economic Review, volume 65, page 195 to 202 Read More