Fiscal Policy

Potential income in the short run is determined by the production possibilities frontier, which is in turn determined by the available supply of factors of production and technical knowledge. Actual national income is determined by the level of aggregate demand and can diverge from potential income. In the real world potential output tends to grow steadily and predictably over time at a rate of 2% to 4%. Actual output fluctuates wildly by comparison . Actual output can be less than, equal to, or greater than potential output. When actual output is too low, unemployment results. When it is too high, inflation results.

The level of national income achieved depends on aggregate demand, which is made up of all those expenditures which make a claim on the output of the domestic economy and therefore create employment and income for domestic factors of production. Specifically, these expenditures are household consumption, business investment, government ependiture, and exports less imports (C+I+G+X-Z). Imports must be deducted because they form a part of the C, I and G expenditures, but do not create a claim on the output of the domestic economy. Increases in aggregate demand can produce increases in output only as long as there are unemployed factors of production. If aggregate demand is just sufficient to maintain capacity output, then full employment and capacity income would be realized. The model developed above suggests that this is the equilibrium value for national output. However, it is possible for equilibrium output (Y_E) to diverge from capacity output (Y_F). If Y_E < Y_F then a deflationary gap exists; if Y_E > Y_F then an inflationary gap exists. Y_E is always at the point where expenditures equal output, but there is no reason why this has to occur precisely at Y_F.

When an inflationary gap exists, the equilibrium point of national output is higher than the capacity national output. National output consists of a flow of final goods and services, represented by q₁..q_N. To calculate the total value of national output, each type of good must be assigned a price p₁..p_N. National output is therefore:

Over time, the value of Y can change for two reasons. First, the actual output flow of goods and services can change, represented by a change in the values of some q_i for the goods being produced at a different rate. Second, the prices of goods and services can change, represented by a change in some values of p_i. In the first case, ‘real’ national income has changed because the flow of goods and services is more or less than it was. In the second case, ‘real’ national income is identical but ‘money’ national income has changed, reflecting a change in the value of money itself relative to ‘real’ goods.

When an inflationary gap exists, Y_E is higher than Y_F. All points higher than Y_F represent changes to Y that result from price changes rather than quantity changes. Thus, so long as Y_E remains higher than Y_F, prices must continue to increase because this is the only way to increase Y given that increased quantities cannot produce values beyond Y_E.

In order to measure national income, there must be a common measure of value to apply to a wide range of goods and services. This common measure is provided by money. The problem with money as a measuring rod, as seen here, is that its value (real purchasing power) can change over time. At a given point in time, a measure of national income can be taken by the summation shown above. But it is also desirable to be able to measure real national income in a way that does not change over time, because actual living standards change with real income, not money income. In order to measure real national income, the set of price weights applicable in one selected period must be applied to the quantities produced in each period under consideration. National income would then be measured in terms of constant base year prices, and any change would reflect a change in real income. In practice, it would be quite difficult to determine, let alone apply, the complete set of price weightings for all goods and services produced in an economy. As an approximation, an index number is calculated which reflects the amount of change in the overall value of money in each year. Current money income can then be adjusted by the index to produce approximate real income. However, price changes are rarely uniform. As the general price level rises or falls, most prices will vary in the same direction, but some prices will vary in the opposite direction. A price index attempts to measure the typical, average ‘basket of goods and services’ representative of living standards or some other desirable factor. Different index numbers are available for different sectors within the economy. The price index used to obtain real GNP is known as the GNP deflator. Other price indexes measure changs in the prices of retail goods, wholesale goods, capital goods, etc. The purpose of all these indexes is to identify the changes in the value of money which have occurred in the area under investigation, and therefore make it possible to compare levels of real income or output from different time periods.

Since equilibrium income can diverge from full employment income (at least in the short run), there is nothing necessarily desirable or undesirable about the level of national income produced by the system. The question then arises: Is the system self-regulating in that departures from full employment income will be temporary, with a long-term tendency for the system to return to full employment; or is the system capable of long-term divergence from the full employment level of national output?

The model developed so far has no provision for a long term tendency towards an equilibrium where Y_E=Y_F. On the conrary, it suggests that planned injections into the circular flow of income are only brought into equality with planned withdrawals through changes to the level of national income/output, so that any level of national output is possible as an equilibrium value. The essence of Keynesian economics is for the government to take action to ensure that actual national output falls as closely as possible to full employment output. This is achieved by allowing the government to ‘interfere’ with the circular flow of income through the application of intentional injections and withdrawals through government expenditure and taxation. This is known as a ‘functional’ fiscal policy, meaning that there is no single automatic rule which must be followed; instead, fiscal policy should be discretionary and should be delibarately altered to suit the prevailing economic conditions, with the goal of producing an equilibrium where Y_E=Y_F.

Not all economists agree with this view. Neo-classical economists of the 1870s, and in more sophisticated form modern monetarists, believe that, given flexible prices, flexible interest rates and a flexible money suply, there will be a tendency for planned savings and planned investment to be brought into equilibrium at or near full employment. Departures from full employment certainly occur, often due to political or monetary disorders, but it is believed that these will be temporary and so long as price flexibility existed, there will always be a tendency to revert towards a situation where full employment without inflation would prevail. Given this view, the government should pursue a balanced budget, thus ‘biasing’ the circular flow as little as possible.

The extreme, or naïve, representation of these arguments is as follows:

·         Keynesian: The components of aggregate demand are independent from each other so that, for example, an increase in G does not have any adverse effect on C, I or X. Therefore creating a budget defecit or surplus will create additional or reduced expenditure in the full amount of the original change. Changes in the government budget balance therefore reflect a substantial injection into or withdrawal from the circular flow of income, and can be used to influence overall national output.

·         Monetarist: The components of aggregate demand are interdependent, so that changes in the budget balance are offset by equivalent changes, of opposite sign, in other components of aggregate demand. In the presence of unemployment, raising G relative to T will not raise aggregate demand and will therefore have no effect on national output, because the increase in government expenditure is at the expense of private expenditure. This is known as the ‘crowding-out’ effect.

The naïve Keynesian view is that the crowding-out effect is zero, while the naïve monetarist view is that it is one. In between there are intermediate values to be considered. At full employment, the crowding-out effect must be unity because any increase in expenditure in one area is at the expense of decreased expenditure in another. When substantial, sustained unemployment exists (as at the time Keynes was writing), a value near zero is probably reasonable. As employment increases, the importance of the crowding-out effect is likely to increase.

If a discretionary fiscal policy is pursued, as shown earlier, an increase in government expenditure provides a larger increase in aggregate demand than does a tax cut of equal magnitude. The ‘first round’ increase in demand from an increase in expenditure is subject only to the government’s marginal propensity to import, but the ‘first round’ increase in demand resulting from a tax cut is subject to both consumers’ marginal propensity to import and their marginal propensity to save. Since changes to expenditures and taxes have differing effect on aggregate demand, a balanced budget does not necessarily imply a neutral effect on the circular flow of money, and in fact it would be possible (though perhaps difficult in practice) for a government to pursue a discretionary fiscal policy while at the same time maintaining a balanced budget.