Thursday, April 15, 2010

IB May 2010 Exams - Economics

The May exams are approaching fast...

I had prepared this for my students and I think that it may be interesting (or, perhaps, even useful) to post here. The usual caveat: listen to your teacher and what he/she has to say before adopting someone else's approach.

Candidates are often asked to evaluate fiscal policy (in HP1 / SP1 or in HP3/SP2) so here are some thoughts:

Evaluating Fiscal Policy

Possible Strengths of Expansionary Fiscal Policy
* Fiscal policy is direct: any increase in government spending will automatically increase national income (Y) by at least as much, if not more
* If the government expenditure multiplier is greater than one (Christina Romer, the Chief Economist of Obama’s Council of Economic Advisors, estimates it at 1.6) then it is also a very powerful tool
* A decrease in taxes to reflate an economy (as part of an expansionary stimulus plan) may also have beneficial supply-side effects as lower taxes may improve the incentives to work and to invest
* In an economy in deep recession (or, depression) interest rates may be at or close to zero, so monetary policy is totally ineffective; in such a case policymakers have only fiscal policy to turn to
* If the institutional framework of the economy is equipped with unemployment benefits and a progressive income tax system then policymakers have the benefits of ‘built-in stabilizers’ (automatic stabilizers)
* If the increased government expenditures of a stimulus package include spending on infrastructure (roads, bridges, harbors, telecommunications etc i.e. physical capital typically financed by governments that create very significant positive externalities decreasing transaction costs across the board), health and education then a positive supply-side effect will also result
* If the increased government expenditures of a stimulus package include spending on the development of ‘green’ technologies then an additional long run benefit will be the improvement of the environment, permitting sustainable growth.

On the other hand (Possible Weaknesses of Fiscal Policy):
* The government expenditure multiplier may even be less than one as some economists claim (Robert Barro of Harvard, is one example)
* There are significant time lags associated with fiscal policy that may even end up destabilizing instead of stabilizing an economy
* Large deficit spending may increase national debt to unsustainable levels and may force significant tax increases in the future (so, in a sense the cost of such a policy is shifted on to future generations)
* There is also the chance that if the fiscal effect continues for longer than needed then inflationary pressures may arise
* There is always the possibility that the increased funding needs of a stimulus plan (remember the Government must borrow from the ‘loanable funds’ market to finance the deficit spending) may crowd-out private investment (and consumption) through a rise in interest rates or even directly (resource crowding-out)
* Also, fiscal policy suffers from an ‘expansionary bias’ because politicians often are irresponsible and prefer to spend more and tax less rather than spending less and taxing more as the former maximizes their short term re-election chances (Greece is now suffering from the ‘fiscal irresponsibility of governments of the last 30 years’….)

Lastly, contractionary fiscal policy to fight inflationary pressures is more difficult to employ compared to increasing interest rates (i.e. tight monetary policy).

On the size of the multiplier see Barro: ; for a more general discussion of the size of the multiplier read this.

Hope this helps.

PS: the word file that you can tweak can be found here at my wikispace as entry #9

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