Why is our debt so high: 1. Financing world war2: Canada is still paying for world war 2. Germany and we just finished paying for world war 1 last year. 2. Increase in income support programs - over 50% of our government spending goes to transfer payment 3. High interest rates in 1970s and 1990s- the stagflation 4. Countercyclical fiscal policy
1) Counter-cyclical (1):
Government spending is used and taxation to close the recessionary and expansionary gaps
recessionary gap - expansionary fiscal policy(increase G or decrease T)
expansionary gap - contractionary fiscal policy( decrease G or increase T)
Problem: Crowding out Effect - government borrowing to finance spending crowds out private investment,If government have lots of debt, its borroing will drive up interest rates and when interest rates are up, Investment spending will go down and real GDP will go down
2) Balanced Budget (2):
Using automatic fiscal policy to prevent extremes
automatic fiscal policy - built into system (subsidies, EI), grows automatically. The economy is capable of returning to full employment equilibrium without discretionary fiscal policy.
Problem: Reducing the deficit at the same time as a recessionary gap causes an increase in unemployment(procyclical - if we increase tax, the recessionary gap will widen, it will push the economy more into the direction it's going already: recession to more recession and expansionary to more expansionary).
3) Cyclical Balanced Budget (3):
Use counter-cyclical fiscal policy to close recessionary and expansionary gaps
Balance the budget over the life of the business cycle( during the recesion we use contractionary fiscal policy and during the contrctionary we use expansionary, it assumes that the size of the expansion is equal to the contractionary, but that is not necessarily the case)
Problem: No guarantees that the size of the recessionary gap will equal the expansionary gap. It is difficult for the government to reign in spending and increase taxes during the expansionary periods.
What are the three theories on fiscal policy? According to each theory, what should scal policy be used to do? What is the problem associated with each theory? 1. Countercyclical Countercyclical scal policy is used to close recessionary or expansionary gaps. Countercyclical scal policy can cause the crowding eect. That is, government spending crowds out investment spending. This is because the government funds spending by selling bonds. The more bonds sold (or the more government debt), the higher the interest rates, which cause a decrease in the number of loans because it is too expensive for rms to borrow. 2. Balanced Budget Balanced budget scal policy uses automatic stabilizers rather than discretionary scal policy. Balanced budget scal policy can cause a pro-cyclical eect. Eorts to balance the budget during a recessionary period can push the economy further into a recession. 3. Cyclical Balanced Budget Cyclical balanced budget scal policy attempts to balance the budget over the business cycle. Countercyclical policies can then be used to close recessionary and expansionary gaps. The problem with cyclical balanced budget policies is that we do not know how long the business cycle will last. In order to be able to balance the budget over the business cycle, the length and magnitude of the recessionary gap needs to be equal to the expansionary gap, which is not always the case.
(1): Dr. S. Powers, "Fiscal Policy" notes, slide 28, April 4, 2012
(2): Dr. S. Powers, "Fiscal Policy" notes, slide 29, April 4, 2012
(3): Dr. S. Powers, "Fiscal Policy" notes, slide 30, April 4, 2012
Why is our debt so high:
1. Financing world war2: Canada is still paying for world war 2. Germany and we just finished paying for world war 1 last year.
2. Increase in income support programs - over 50% of our government spending goes to transfer payment
3. High interest rates in 1970s and 1990s- the stagflation
4. Countercyclical fiscal policy
1) Counter-cyclical (1):
Government spending is used and taxation to close the recessionary and expansionary gaps
recessionary gap - expansionary fiscal policy(increase G or decrease T)
expansionary gap - contractionary fiscal policy( decrease G or increase T)
Problem: Crowding out Effect - government borrowing to finance spending crowds out private investment,If government have lots of debt, its borroing will drive up interest rates and when interest rates are up, Investment spending will go down and real GDP will go down
2) Balanced Budget (2):
Using automatic fiscal policy to prevent extremes
automatic fiscal policy - built into system (subsidies, EI), grows automatically. The economy is capable of returning to full employment equilibrium without discretionary fiscal policy.
Problem: Reducing the deficit at the same time as a recessionary gap causes an increase in unemployment(procyclical - if we increase tax, the recessionary gap will widen, it will push the economy more into the direction it's going already: recession to more recession and expansionary to more expansionary).
3) Cyclical Balanced Budget (3):
Use counter-cyclical fiscal policy to close recessionary and expansionary gaps
Balance the budget over the life of the business cycle( during the recesion we use contractionary fiscal policy and during the contrctionary we use expansionary, it assumes that the size of the expansion is equal to the contractionary, but that is not necessarily the case)
Problem: No guarantees that the size of the recessionary gap will equal the expansionary gap. It is difficult for the government to reign in spending and increase taxes during the expansionary periods.
What are the three theories on fiscal policy? According to each theory, what should scal
policy be used to do? What is the problem associated with each theory?
1. Countercyclical
Countercyclical scal policy is used to close recessionary or expansionary gaps.
Countercyclical scal policy can cause the crowding eect. That is, government spending
crowds out investment spending. This is because the government funds spending by
selling bonds. The more bonds sold (or the more government debt), the higher the
interest rates, which cause a decrease in the number of loans because it is too expensive
for rms to borrow.
2. Balanced Budget
Balanced budget scal policy uses automatic stabilizers rather than discretionary scal
policy.
Balanced budget scal policy can cause a pro-cyclical eect. Eorts to balance the
budget during a recessionary period can push the economy further into a recession.
3. Cyclical Balanced Budget
Cyclical balanced budget scal policy attempts to balance the budget over the business
cycle. Countercyclical policies can then be used to close recessionary and expansionary
gaps.
The problem with cyclical balanced budget policies is that we do not know how long the
business cycle will last. In order to be able to balance the budget over the business cycle,
the length and magnitude of the recessionary gap needs to be equal to the expansionary
gap, which is not always the case.
(1): Dr. S. Powers, "Fiscal Policy" notes, slide 28, April 4, 2012
(2): Dr. S. Powers, "Fiscal Policy" notes, slide 29, April 4, 2012
(3): Dr. S. Powers, "Fiscal Policy" notes, slide 30, April 4, 2012