Cycles and Stabilisers

The latest edition of Deutsche Bank’s Global Economic Prospects has a fine analysis of the likely impact of the fiscal stimulus on aggregate demand, output and prices - there is some excellent evaluation points here for AS and A2 students - summarised below:

A fiscal stimulus can come from several sources

Higher government spending (current, capital and welfare spending)
Reductions in taxation (direct and indirect, business and household taxes)
A rise in government borrowing (some of which is the working of the automatic stabilisers, the rest is a discretionary decision to raise borrowing)

The impact of any fiscal stimulus depends on a number of factors - these factors help to determine the size of any fiscal multiplier effect and also the likely time lags between a change in fiscal policy and its impact on macroeconomic variables.

Five contributory factors are discussed:

1/ Design - i.e. tax cuts or higher government spending. OECD evidence is the the multiplier effects of direct increases in G are higher than for tax cuts or increased transfer payments

2/ Financial Stress - fiscal policy is operating in highly unusual and uncertain times. Uncertainty about job prospects, future income and inflation levels might make people save tax cuts. On the other hand if consumers are finding it hard to get fresh lines of credit, they may decide to consume a high percentage of any boost to their disposable incomes.

3/ Temporary or permanent fiscal boost - much depends on whether businesses and consumers expect higher government spending / borrowing / taxation in the future. Expectations of the future drive behaviour today ... most of us now expect taxes to have to rise in the coming years. Will this prompt a higher level of household saving and a paring back of spending and private sector borrowing?

4/ Monetary policy response - in the jargon ... does monetary policy accommodate the fiscal stimulus (i.e. there are no offsetting rises in interest rates)? Consider a situation in 2010-2011 when the Bank of England holds policy interest rates close to 1% even if inflationary pressures are rising - this will drive down real interest rates and perhaps boost demand still further. But the central bank has an inflation target to consider and Mervyn King has already given a clear public warning that he feels the fiscal stimulus has been large enough.

5/ Openness of the economy - the more open an economy is (i.e. the higher is the ratio of imports and exports to GDP) the greater the extent to which higher government spending or tax cuts will feed their way into rising demand for imported goods and services, lowering the impact on domestic GDP. This will be in the news in the days ahead when the car scrappage scheme is announced - 80% of new cars sold in the UK come from overseas.

There is an important sixth factor - the spillover effects from the fiscal and monetary policies being applied in other countries .... it is always good evaluation to comment that modern economies are inter-related so what happens to government borrowing and interest rates in the EU, the USA and in many emerging market countries will have an important bearing on prospects for a broadly based recovery in global trade and output.

So the huge fiscal stimulus must provide a boost to demand, but the final impact is shrouded in uncertainty - such is macroeconomics!

And incidentally the DB analysis suggests that most of the stimulus is simply the working through of automatic stabilisers!