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The stabilizing role of fiscal policy: Measuring it and evaluating its effects

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
March 1984
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Measuring it and evaluating its effects

Sheetal Chand

The government’s budget plays an important and pervasive role in the functioning of most economies. Thus, government expenditures are a source of stimulus, while financing them through higher taxes can be contractionary as purchasing power is siphoned away from the taxpayer. Government borrowing from domestic nonbank sources through bond issues to finance outlays can also be contractionary, unless the private sector has excess savings.

In the postwar period, and reflecting the Keynesian revolution in economic thinking, many governments have sought to use the budget to stabilize the economy. Such use, however, has been controversial. Fundamentally, the debate concerns whether or not fiscal policy can smooth out fluctuations in the business cycle and related changes in employment growth, although it also concerns the effects of stabilization efforts on the inflation rate and other policy goals, particularly the balance of payments.

In what follows, certain aspects of a stabilizing fiscal policy are reviewed, with emphasis on how to measure and evaluate its stabilizing effects. Policymakers frequently rely on indicators or summary measures to gauge the stance of a budget, its stimulative effects, and their likely magnitude. But choosing the appropriate indicator is not simple, for the budget’s interaction with the economy is complex.

Selecting indicators

The budget interacts with aggregate demand and supply in a typical modern industrial economy through various channels. It can directly affect the market for goods and services through the government’s procurement policies. Indirect effects are exerted in several different ways: one important channel is through expectations and, hence, the behavior of individuals. For example, if the authorities run a higher fiscal deficit, individuals may expect higher future taxes to finance the deficit, and may increase current savings—which would then frustrate the direct expansionary effect of fiscal policy. Alternatively, if the higher fiscal deficit is financed by borrowing in the financial markets, interest rates could rise and might crowd out some private expenditure. This again could frustrate the directly stimulative effect of policy. The successful operation of fiscal policy requires that at least some of these indirect reactions be taken into account.

However, in practice it is difficult to take full account of the diverse effects of fiscal policy (distinguishing between their immediate and ultimate outcomes). Some simplifying conventions are needed. One major simplification is to consider only the initial short-run effects of budgets on aggregate demand. A horizon of one year for the analysis is appropriate because it generally coincides with the annual budget cycle in many countries. Nevertheless, it is important to have some idea of the longer-run effects and the likely impact of other policies.

A second convention concerns the degree to which to disaggregate the budget. Not all components have the same impact on the economy: instead of increasing domestic demand, for instance, a budget outlay may result in higher imports that do not stimulate the domestic economy; interest payments on higher debt, too, may be less stimulative than the extension of unemployment benefits, as the recipients of the former are likely to have a higher marginal propensity to save than recipients of the latter. However, typically the details required for a disaggregated analysis are lacking, so attention usually has to be confined to some overall budget concept.

Keynesians and monetarists use different budget concepts. The former stress a balance struck by netting government expenditures against revenue, which is appropriate for a goods market analysis, while monetarists generally prefer a liquidity balance concept that relates to the degree of bank financing of the budget. It is a matter of debate which of the two indicators to employ. Monetarists choose a liquidity balance concept because they believe that even in the short run the money stock and the level of aggregate demand are closely related. Keynesians dispute this connection for the short run and argue instead for a direct identification of the effects of the budget on aggregate demand rather than via a money stock proxy. In practice, for a shorter-run analysis of output and employment effects, a Keynesian budget balance is the preferred choice of many national governments. Keynesians tend to argue that the liquidity definition is more appropriate for assessing the budget’s contribution to growth in the money supply and, hence, to the longer-term inflation-generating process.

In any event, the usefulness of either indicator will depend on the stability of the underlying budget composition over the given period. If there are dramatic shifts within it in the relative shares of major components, the assessed effects of a given budget balance may be different from the actual impact. As a precaution, when employing an overall budget concept it is useful to note whether or not there have been or are likely to be any underlying compositional changes. It is also important to specify at the outset the purpose for which the indicator is to be employed, for different indicators are appropriate for different purposes. This is considered further below.

Using indicators

It is a common fallacy to take a selected budget balance and to view both it and its movements as direct indicators of the stance of policy. For a given tax and expenditure structure, however, a different budget balance will result when the economy is booming, for instance, than when it is stagnating. Consequently, it can be erroneous to infer directly from an increase in the budget deficit that fiscal policy has become more stimulative or that it will lead to crowding out of private expenditure; a weakening economic situation could equally well have caused the widening deficit. It is important, therefore, to take note of the underlying state of the economy.

There are essentially two ways to adjust for the effects of the economy on the budget. One involves controlling for fluctuations in the level of economic activity, and is the so-called full employment balance method developed by the Council of Economic Advisors in the United States. Here the procedure is to ask what the budget balance would be at an assumed full employment level of the economy. Those elements of the budget, such as revenue or unemployment benefits, that are sensitive to the cycle, will be affected by this estimation. The resulting Full Employment Budget Balance will then be invariant with respect to the given full employment level of income, unless the level of discretionary expenditures or the structure of taxation are modified. Hence, the expansionary implications of different budget structures (fiscal policies) can be ranked by looking at the size of their full employment deficits. The bigger the full employment deficit, the more expansionary the budget is judged to be.

Another way to handle the effect of the business cycle on the budget is first to select a base year budget balance with desirable properties. The latter include those of being appropriately aligned with respect to the corresponding balances of the private and external sectors in a year for which the overall performance of the economy is judged satisfactory. Movements in this budget balance are then computed that are cyclically neutral, using the trend rate of growth in GNP, or direct estimates of potential output, to determine the “neutral” growth in government expenditure, while “neutral” revenue is that which grows equiproportionately with actual GNP. The justification for such criteria is straightforward. A growth in government expenditure that is in step with the enlargement of the productive potential of the economy does not contribute to excessive pressure. However, because revenue responds to actual GNP growth, it should grow in step with GNP for the revenue side of the budget to be neutral in its impact on aggregate demand. Of course, if revenue grows more rapidly, it will be exerting a contractionary effect (fiscal drag) on the economy. It should be noted that the revenue criterion is used in assessing whether or not the revenue response is nonneutral, which is not the same as identifying discretionary revenue policy, unless the underlying responsiveness of revenue with respect to GNP growth (the so-called built-in elasticity) is unity.

The next step is to test an actual budget balance against that year’s cyclically neutral balance. If the actual budget deficit, say, exceeds the adjudged cyclically neutral deficit, the cyclical effect of the budget is deemed expansionary and conversely. This difference is defined in the box and is referred to there as the cyclical effect of the budget. Such a measure, however, is highly sensitive to the choice of base year balance. A more robust indicator is provided by considering the year-to-year change in the budget indicator described above (i.e., in the CEB in the box). This measure of the fiscal impulse indicates the initial contribution to the annual fluctuation in aggregate demand.

The different techniques described above for adjusting a budget balance focus on real (employment-affecting) fluctuations. However, an observed budget outcome can reflect the operation of several factors. The pursuit of a more expansionary fiscal policy will cause a budget deficit to widen. At the same time this policy may stimulate higher output, domestic price inflation, and a larger volume of imports. If revenue is sensitive to these factors, an improvement in the budget balance could result, although not generally of a magnitude to completely offset the initial increase in the budget deficit. In addition, factors operating independently of the budget may have led to a higher rate of inflation or a deterioration in the terms of trade that also exerted effects on the observed budget outcome. How should such “non-output” related effects, whether or not induced by the budget, be handled in the assessment of fiscal policy?

The preceding question can be answered in different ways which, in turn, can lead to additional adjustments to the budget balance measure. Thus it can be contended that fiscal policy should not be agnostic with regard to domestic inflation and that a normative (acceptable) rate of inflation should form part of the analysis. It might also be argued that any inflation-induced interest rate increase that raises outlays on the public debt should be excluded from the budget balance, as it could give the misleading impression that fiscal policy is more expansionary, when all that has occurred is that private holders of government debt have been compensated for an erosion in the real value of their holdings.

Budget indicators

In order to obtain a simple indicator of the effect of the budget on the economy (i.e., aggregate demand), first determine a cyclically neutral balance (CNB). G° – T°, (where G = government expenditures, T = receipts in base year, o) denotes the balance in some base year of satisfactory performance. The CNB for each year is determined by applying the base year revenue to GNP ratio (to) to that year’s actual output level and the base year expenditure to GNP ratio (go) to that year’s potential (trend) output level; the difference is the CNB.

Next, the computed CNB is subtracted from the actual budget deficit for that year to determine the so-called cyclical effect of the budget (in real terms): CEB = G – T – [g°Yp – t°Y] with Y representing GNP and the superscript ρ its potential level. A positive CEB indicates an expansionary budget effect and conversely. This value is zero for the base year.

A simple way of identifying the “structural” or underlying balance component of a particular year’s budget is to take the base year balance defined above and to add to it the cyclical effect of the budget (CEB) for that year—see table below for an illustration based on U.S. data. The CEB provides a rough estimate of the amount of additional revenue or reductions in expenditure needed to restore the base year balance. In this case 1978 has been selected as the illustrative base year.

U.S. Federal Government fiscal data, 1978–831(In percent of GNP)
787980818283
Actual budget balance (a)2.01.22.42.54.36.3
Cyclically neutral balance (b)2.02.02.82.94.24.5
Cyclical effect of budget (CEB = (a) – (b))2-0.8-0.4-0.40.11.8
Fiscal impulse (ACEB)-0.80.40.51.7
Base year balance (1978) (c)2.02.02.02.02.02.0
Structural budget balance (CEB + (c))2.01.21.61.62.13.8
Source: IMF data.

Denotes negligible amount.

All budget balance data represent deficits. The data have been adjusted to a cash, calendar year basis and include social security transactions in accordance with standard IMF usage.

– represents a contractionary effect.

Source: IMF data.

Denotes negligible amount.

All budget balance data represent deficits. The data have been adjusted to a cash, calendar year basis and include social security transactions in accordance with standard IMF usage.

– represents a contractionary effect.

A major drawback with these and other adjustments that have been proposed is that they render the summary measure more complex. Moreover, it is not altogether clear that such adjustments should be rendered to a measure of fiscal policy, given the standard definition of fiscal policy as comprising those transactions that affect the budget balance and thus the growth in the public debt, while assigning responsibility for its composition and valuation to monetary policy. Several implications follow from observing the preceding definition. First, to the extent inflation is regarded as a monetary phenomenon, while the dominant concern of fiscal policy is stabilizing output, a case can be made for separating the two objectives. Second, regarding the treatment of higher inflation-induced interest outlays, it may be preferable not to make any exception for them in the assessment of fiscal policy per se, but to take account of their possible implications when analyzing private sector behavior. This is particularly appropriate if there is doubt as to how private spending behavior will respond to an inflation-related debt adjustment. Third, it could be argued that the budget’s effects on interest rates (that bear on issues such as crowding-out) should not form part of the fiscal assessment, on the grounds that they are more appropriately treated in the monetary analysis. Nevertheless, the fact that such issues can be raised points to the need for caution in the use of the fiscal measures. It is important that some of the wider implications of the factors noted above are not lost sight of, even though they do not form part of the fiscal measure.

Another issue is how to draw inferences about unemployment, real output growth, or the rate of inflation from a given aggregate effect on demand of fiscal policy. Fortunately, it is possible to use the fact that inflation and real growth in a modern industrial economy normally respond to stimuli with different lags. Typically, in a context of moderate or low inflation, the initial impact of aggregate demand changes is on output or employment growth, as prices tend to react more slowly owing to the prevalence of wage and price contracts. It can be plausibly assumed that in a year-to-year analysis of the effects of fiscal policy, the impact is primarily on real output, while the inflationary consequences are manifested somewhat later. Notwithstanding some potentially important longer-term effects, fiscal policy can thus be employed in the short-run for the goal of smoothing output and, hence, employment fluctuations. In this approach, fiscal policy is used to offset shifts in the major private components of aggregate demand, especially private fixed investment, that generate short-run fluctuations in output.

Nevertheless, there is a question whether the longer-run effects of fiscal policy can reverse the shorter-run impact. As an empirical generalization it would seem that the demand effects of a budget deficit tend to be absorbed by the economy over the relatively short horizon of a year or so. Thus suppose there is a stimulative increase in the fiscal deficit for a given initial state of the economy. The increase in aggregate supply that is induced, partly through higher imports, will help restore equilibrium in a formal sense. In part there will be income-induced increases in private saving that offset greater government dissaving, with the remaining difference covered through a larger current account deficit. If the new budget deficit level is maintained, there will be no more (demand) stimulus, at least in a direct sense. Yet there will be effects that tend to influence the supply side of the economy and thus the trend rate of growth of the economy. This is because a higher fiscal deficit is associated both with financial effects, such as a higher rate of public debt issue that can cause interest rates to rise, and with possible direct real effects on the rate of capital accumulation and on the structure of incentives. Consequently, it is meaningful to undertake two analyses of fiscal policy effects, one on the shorter-run cyclical aspect and one on the longer-run trend.

For a longer-run analysis, it is especially important to decide on the appropriate level of a budget deficit that would be compatible with both internal and external balance over the medium term. Such a calculation requires an assessment of the sustainable current account deficit of the balance of payments, which, in turn, is based on notions of probable capital flows and also an estimate of the net private sector savings balance to be expected. On adding these two balances, an indication is obtained of the appropriate size of the “underlying” fiscal balance, which can then be used to assess whether or not the underlying balance associated with any particular year’s budget is acceptable (see box for this calculation).

The U.S. business cycle

It is instructive to apply some of these ideas to assess the use and success of fiscal policy in stabilizing the real business cycle in the United States, which has exhibited substantial amplitude (Chart 1). What is intriguing, however, is the marked compression in the amplitude of the cycle in the postwar period as compared to the interwar years, and the reasons for this phenomenon.

Chart 1The U.S. business cycle, 1921–81

Source: IMF data.

In order to assess the possible role of fiscal policy, it is necessary first to identify its stance. Chart 2 uses the indicator of fiscal policy set out in the box (year-to-year change in CEB) to plot the initial aggregate demand effects of the budget. This series fluctuates considerably, especially in the postwar years, but this by itself does not convey much. The direction of policy is conveyed by the indicator plus a second series concerning fluctuations in employment growth. To stabilize employment growth, fiscal policy should obviously be more expansionary in periods of sluggish employment growth and conversely. However, Chart 2 shows that, with the exception of 1932, fiscal policy was generally procyclical in the interwar years—contractionary when employment growth declined and expansionary when it increased. This result is not surprising in view of the then pervasive belief that the budget be balanced at all times. In a sluggish economy the budget tends toward a deficit (as revenues decline), so that attempting to balance the budget involves a contractionary reduction in expenditures or an increase in taxes, which further aggravates the recession.

Chart 2Fiscal impulses and growth in employment in the United States, 1921–811

Source: IMF data.

1 Fiscal impulses in percent of previous year’s GNP. Employment as defended annual growth.

In the postwar period the fiscal impulses appear to be systematically countercyclical. In order to measure their contribution to stabilizing the real business cycle, it is necessary to examine major proximate determinants—principally private fixed investment and exports. The latter two so-called autonomous impulses, to which state and local government expenditures have been added, are plotted in Chart 3. As is evident for the postwar period, increases in the autonomous impulses have usually been accompanied by a contractionary fiscal policy, and conversely. The overall outcome for output and employment should now be more favorable and, indeed, is observed in the much more stable real business cycle of the postwar period that is shown in Chart 1. Although sophisticated econometric tests are needed to establish more precisely the contribution of fiscal policy, the association of a countercyclical fiscal policy and a smoother business cycle is highly suggestive.

Chart 3Fiscal impulses and autonomous impulses in the United States, 1921–811

Source: IMF data.

1 Fiscal and autonomous impulses in percent of previous year’s GNP. Autonomous impulses are mainly private fixed t and exports.

According to the so-called macro rational expectations hypothesis, policy, when it can be anticipated, is ineffective. The results presented above demarcate two periods with distinctly different fiscal policy rules—a balanced budget rule in the interwar years and a countercyclical budget rule in the postwar years. Consequently, if the rational expectations hypothesis is valid, the switch in policy rules should not have mattered. But it appears to have done so, suggesting that policies can be effective provided there are some policy rules that will induce individuals to behave differently. A fiscal policy rule of balancing the budget, irrespective of the state of the economy, will make individuals excessively cautious in their spending behavior, whereas an assurance that the excesses of the business cycle will be contained could induce a steadier response.

Application to LDCs

The criterion discussed for assessing fiscal policy is tailored to the circumstances of industrial countries. For applications to the developing world, account must be taken of their special structural characteristics affecting both the economy and the budget. For example, the problem of unemployment in many developing countries may not be the result of deficient aggregate demand in the conventional Keynesian sense but of structural bottlenecks and impediments to the smooth functioning of markets. Hence, using a more expansionary fiscal policy to curb unemployment might simply worsen the balance of payments deficit or increase the rate of price inflation, with limited effects on employment. Nevertheless, even though structural unemployment tends to be higher in developing than in industrial economies, they, too, can be subject to cyclical influences, often related to an export cycle. A cautiously applied countercyclical fiscal policy may be appropriate—provided the country has adequate reserves, as the balance of payments deterioration will be more extreme when the budget stimulates demand and, hence, imports in a context of export shortfall. For many developing countries, the primary focus of a countercyclical fiscal policy is not on employment, but rather with smoothing the rate of absorption of domestic and foreign goods and services. The latter objective can be important in promoting growth and, certainly, the welfare of the economy.

Particular attention needs to be paid to the structure of the budget, including its financing. For many developing countries, the budget is highly sensitive to international factors. Export earnings from a few primary commodities may be a major source of budget revenue, while expenditures, particularly with regard to the development or capital budget, have a large import content. Even some current outlays may be powerfully affected by international developments, such as, for example, a deterioration in the terms of trade that raises the subsidy element borne by the government in the price of essential imports. Financing the budget deficit can also depend heavily on international sources, as the scope for domestic nonbank financing is limited, and a shortage of foreign exchange may constrain recourse to domestic credit creation.

If there is a heavy dependence on international factors, the assessment of fiscal policy undertaken at the level of the overall budget balance can be misleading. For example, a deterioration in the terms of trade or higher interest outlays on external debt can lead to a much bigger overall budget deficit, suggesting a more expansionary fiscal policy, although the domestic impact of the budget could actually be contractionary. The latter would be the case if domestic outlays are reduced or domestic activity is more intensively taxed in order to pay for the externally induced deterioration in the budget. A distinction should then be drawn between the domestic and foreign components of the budget, with items such as export duties assigned to the foreign component, for example, so as to identify their respective contributions to internal and external balance. Conceptually at any rate, this split of fiscal policy into separate instruments can be advantageous in promoting internal and external stability. Thus, in order to promote external balance, it may be preferable to aim at a surplus in the foreign budget balance, rather than in the domestic component, so as to avoid aggravating a local recession. The adjustments discussed above for identifying an expansionary fiscal policy need be applied to the domestic component only, as the foreign part is usually determined either at the discretion of the authorities or by external (exogenous) factors such as the terms of trade.

However, even with the domestic budget balance, more circumspection must be exercised in applications to the developing world for the purpose of assessing effects on the level of domestic activity. It is possible that the inflation lags are much shorter than in industrial countries, either because the underlying rate of inflation is much higher, or wages and prices are less sticky. Hence, an expansionary fiscal policy may have limited impact on the rate of growth of employment or output but more on the inflation rate and, via absorption, on the balance of payments. These structural differences must be taken into account in determining the appropriate goals of a short-run demand-oriented fiscal policy. Often among the developing countries, an expansionary domestic budget is the root cause of inflation and a deteriorating balance of payments, even though the overall budget balance may appear acceptable. This is attributable to the general dominance of the domestic budget in such economies, both as an initiator of activity and as a vehicle for increasing the money supply. A more satisfactory balance of payments will frequently require a less expansionary domestic budget impulse. For this purpose the summary indicator described earlier can assist in determining whether or not a budget is expansionary and the order of magnitude of the stimulative effect.

Conclusion

Governments are typically concerned with many objectives and employ several alternative instruments to promote them. Fiscal policy is only one such instrument and the discussion above has focused on its use for the narrow purpose of stabilizing real output growth. Although important, this emphasis should not obscure the essentially short-run nature of the policy and the importance of maintaining a longer-term perspective on the appropriate budget profile. When focusing exclusively on the stabilization needs of the moment, it is quite easy for a budget to deviate further and further away from the norm compatible with medium-term growth and stability. A useful corrector is the attempt to ensure that the sum of each year’s budget balance averages to that of the norm over a run of years for which the cyclical effects even out.

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