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Macroeconomic Theory Chapter 5: Fiscal Policy Roles of Fiscal policy To provide automatic stabilizers to insulate the economy from shocks to AD (tax and social security). To stabilize output around eq. rate using discretionary fiscal policy (another policy). To plan the financing of g and to maintain a sustainable burden of public debt. The Automatic Stabilizers Tax and benefit system depend on the level of activity. They reduce the size of the multiplier and dampen the impact of any exogenous changes in private spending on output. As a consequence budget deficit rises when activity falls and declines when activity rise. Calculating the cyclically adjusted budget deficit, the deficit that would prevail given existing taxes and spending commitments if the economy was operating at ye, this indicates whether fiscal policy is expansionary or contractionary. Fiscal stance: Primary B. deficit=cycl. Adj. B. deficit + impact of aut. stabilizers =discret. fiscal impulse + impact of aut. stabilizers g(yt) – t(yt) ≡ [g(ye) – t(ye)] + a(ye – yt) discretionary fiscal. Impulse automatic Stabilizers During recession a(ye – yt)0, pushing up B. deficit and vice versa. At ye; a(ye – yt) = 0. A cycl. Adj. B deficit ? expansionary fiscal stance A cycl. Adj. B surplus ? contractionary fiscal stance If the cycl. adj. surplus or deficit = 0 ? the actual deficit reflects the automatic stabilizers and will disappear once the economy returns to eq. When we have cycl. adj. deficit, the govt. has to recognize that eventually it may have to take measures to reduce the increase in debt when the economy returns to ye. Discretionary fiscal policy In the IS/LM g is normally assumed to be exogenous, t is either exogenous or a function of income. So far we did not consider how the increase in g is financed. First, assume that house