Automatic stabilizers for fiscal policy

Table of Contents

Executive Summary

List of Abbreviations

List of Figures

1 Introduction

2 Main Part
2.1 Government’s policies for stabilization of economic cycle
2.2 The influence of public expenditure on GDP
2.2.1 The multiplier effect
2.2.2 The crowding-out effect
2.3 Automatic stabilizers
2.4 Impact of the fiscal stabilizers on businesses

3 Conclusion

4 ITM Checklist

List of Abbreviations

illustration not visible in this excerpt

List of Figures

Figure 1 – The multiplier as a function of the marginal propensity to consume.

Figure 2 – The influence of public expenditure on the money market.

Figure 3 – The influence of public expenditure on the aggregate demand.

Figure 4 – The lags in implementation of fiscal policy.

Figure 5 – The multiplier by different tax rates.

Figure 6 – Reduction of GDP fluctuations by means of automatic stabilizers.

Executive Summary

The object of this study is to analyze the influence of fiscal policy, in particular of the public expenditure, on the stabilization of business cycle. Moreover, the functional principle of automatic stabilizers and the impact of fiscal stabilizers on businesses are studied.

The condition for a steady economic development is achievement of stability targets like full employment of production factors, monetary stability, balancing of payment as well as equilibrium of foreign trade. To counteract the economic fluctuations government can apply two stability tools: the fiscal and the monetary policy. These both policies affect the aggregate demand and contribute to stabilize short-run economic fluctuations.

The principle of the fiscal policy is an adjustment of public expenditure and public revenue (taxes) in according to the economic situation. A higher public expenditure leads to an increasing of the aggregate demand. The total change in GDP is depending on two opposite macroeconomic effects: the multiplier and the crowding-out effect. The multiplier effect results, that the total change in demand as well as in GDP can be a multiple of the initial public expenditure. Contrary, the crowding-out effect leads to a reduced aggregate demand due to the aligned increasing of interest rate. The impact of public expenditure on GDP depends on whether the multiplier effect or the crowding-out effect is stronger.

An opportunity to avoid problems of lags in implementation by using of the fiscal policy is automatic stabilizers, e.g. tax system and government spending. They enable an automatic adjustment of the aggregate demand without additional actions or interventions of policymakers. The fiscal stabilizers have a positive impact on various businesses, but with different degrees.

It could be summarized, that the fiscal policy affects both the aggregate demand and the aggregate supply. By means of fiscal stabilizers economic fluctuations could be smoothen.

1 Introduction

Image, that you are an entrepreneur and owner of a company in the building industry. Unfortunately, you are now in a difficult situation. After several booming years, the economics of your country stagnates. The export breaks down and the demand for goods and services drops in many sectors. The economic recession leads to a dramatic decline of your business. You have not enough orders for a long time and are constrained to lay off employees. You terminate agreements with the vendors and their subcontractors suffer in turn from this chain reaction. The situation is threatening and you are looking for a new solution.

At the beginning of the year you heard on radio about a government program to stimulate the economy. The government plans to cut taxes and increase public expenditures. Particularly for the building industry, a new program for first-home buyer allowance will be introduced again. That would encourage people to finance their own home. But the best news you got from the management board this morning. Your company was selected for a consortium to build the new stadium “Bavarian Arena”, which is financially supported by the Bavarian government. Moreover, you get a new contract to setup some all-day schools in the region. What a lucky day. Your company, your vendors and their subcontractors are saved. From your MBA study 10 years ago, you know, that is the wonder of the fiscal policy.

The object of this study is to analyze the influence of fiscal policy on the stabilization of business cycle. The effect of public expenditure on Gross Domestic Product (GDP) is studied. Furthermore, the functional principle of automatic stabilizers and the impact of fiscal stabilizers on businesses are discussed.

2 Main Part

2.1 Government’s policies for stabilization of economic cycle

The condition for a steady economic development is achievement of stability targets like full employment of production factors, monetary stability, balancing of payment as well as equilibrium of foreign trade. A typical economic cycle consists of upturn and downturn periods which can be divided into economic growth, booming, recession and depression phases. To counteract the economic fluctuations government can apply two stability tools: the fiscal and the monetary policy. These both policies affect the aggregate demand and contribute to stabilize the short-run economic fluctuations.^[1],^[2]

In Europe, the monetary policy is determined by the European Central Bank (ECB). The ECB controls the level of the money supply and the interest rate. Hence, it influences the level of economic activity in the whole Euro area. To boost the economy in the downturn period, an expansionary (or reflationary) monetary policy will be applied. Thereby, the level of interest rate will be reduced and the growth rate of the money supply will be increased. Conversely, in the upturn period, a contractionary (or deflactionary) monetary policy should be chosen to slow down the economic activity. That includes increasing the level of interest rate and reducing the growth rate of the money supply.^[3]

On the other way, the government of individual EU country can affect directly the level of economic activity by means of its national fiscal policy. Thereby, public expenditure (public consumption and invest) and public revenue (taxes) are adjusted in according to the economic situation. The principle is very simple: more public expenditure and less public revenue in the downturn period as well as less public expenditure and more public revenue in the upturn period. For example, in order to encourage more spending and boost the economy in the downturn period, an expansionary fiscal policy with reducing levels of direct tax (income tax) or indirect tax (value added tax) and increasing government expenditure will be applied. In contrast, a contractionary fiscal policy should be utilized in the upturn period. By means of increasing taxation and cutting government expenditure, the level of demand in the economy and the inflation can be reduced.^[4],^[5]

The fiscal policy is particularly required, when drop in demand in the recession phase is so intense, that the interest rate is close or equal to zero or when the propensity to invest does not react to the changing in the interest rate. Moreover, the fiscal policy can affect directly the aggregate demand. In comparison, the monetary policy can be applied very quickly and is reversible at any time. However, the impact of the monetary policy has a long and variable lag of time.^[6]

2.2 The influence of public expenditure on GDP

The GDP (denoted as Y) is defined as a sum of consumption (C), investment (I), government purchases (G), and net exports (NX). The net exports result from export and import values (NX = Exports – Imports).^[7]

Y = C + I + G + NX (1)

To get a higher level of economic growth (growth in GDP) the government can increase its public expenditure (G). The additional need of government for goods and services leads to an increasing of the aggregate demand. Consequently, the demand curve shifts to the right. Thus, the government can affect directly the aggregate demand by raising its public expenditure. But how would the GDP change? It is more are less than the change in the public expenditure (G)? Two different macroeconomic effects will give the right answer for this question: the multiplier and the crowding-out effect.^[8]

2.2.1 The multiplier effect

The higher government expenditure involves that companies get additional contracts to deliver needed goods and services to the government. This leads to higher profits of the companies and higher employment as well as higher incomes of the employees. Hence, the companies would spend more for consume and investment goods and the private consumption of employees would be increased. Consequently, the aggregate demand in the economy and the change in GDP will be larger than the initial public expenditure (figure 3). This effect is called multiplier effect.

To calculate the total change in aggregate demand due to the enhanced public expenditure, the marginal propensity to consume (c) is needed. This value (c) tells us, how many would the household spend from its extra income. For example, a value (c) of 0.8 means, that the household would spend 0.8 of the extra income and save 0.2 of it. This leads to the result, that if the government increases the public expenditure by €100 m, the change in consumption in the first run is equal to (c x €100 m) and in the nth run to (cn x €100 m):^[9]

illustration not visible in this excerpt

The total change in demand as well as in GDP will be a multiple of the initial public expenditure. The multiplier and the change in GDP can be calculated as follows:

Multiplier = 1 + c + c2 + c3 + … cn = [illustration not visible in this excerpt](2)

[illustration not visible in this excerpt ](by constant keeping of other parameters)^[10] (3)

The dependence of the multiplier on the marginal propensity to consume (c) is shown in figure 1. It could be stated, that the multiplier is strongly increased by higher (c) values, particularly by (c) larger than 0.8. A value (c) of 0.9 would lead to a multiplier of 10. That means that a change in the public expenditure by €100 million would result in €1 billion change in the aggregate demand as well as in GDP by a marginal propensity to consume of 0.9.

[...]

^[1] Lachmann (2006), p. 234.

^[2] Mankiw et. al (2006), p. 532.

^[3] Available from http://www.bized.co.uk/virtual/economy/library/glossary/glossarymp.htm (accessed on 20.02.2008).

^[4] Lachmann (2006), p. 237–240.

^[5] Available from http://www.bized.co.uk/virtual/economy/library/glossary/glossarymp.htm (accessed on 20.02.2008).

^[6] Bofinger (2003), p. 358.

^[7] Mankiw et. al (2006), p. 532.

^[8] Mankiw et. al (2006), p. 721.

^[9] Mankiw et. al (2006), p. 723.

^[10] Lachmann (2006), p. 244.