Question

Consider an economy that has been steadily expanding for several years and is expected to continue growing at the same pace in the next couple of years. In this period, the ratio of budget deficit to GDP has been about 3 percent and public debt-GDP ratio has hovered around 100 percent. Both ratios as well as the interest rate and the inflation rate have been steady and are expected to remain so if economic growth continues at its current pace.

However, this year a temporary reduction in the prices of imported production inputs is generating above-trend incomes in the private sector, which is raising tax revenues. Everyone expects this favorable shock to be limited to this year. They also realize that there could be unforeseen shocks in the coming years that may shift the IS curve to the right or to the left, requiring the government to change fiscal policy to ensure the economy’s stability. Assume that the country’s creditors would be willing to lend more to the government at the current interest rates only if the government commits to raise tax rates in the following three years and pay back any additional debt that it takes on.

In this situation, if the government wants to pursue optimal fiscal policy, this year it should

	a.	keep the tax rate steady and raise fiscal expenditure to maintain the deficit-GDP ratio.
	b.	keep the tax rate and expenditure on course to let the deficit-GDP ratio to decline this year and provide room for increased expenditure in future years if need arises.
	c.	lower the tax rate, while keeping fiscal expenditure on course to maintain the deficit-GDP ratio.
	d.	lower the tax rate and raise fiscal expenditure by borrowing more to stimulate aggregate demand.

Answer 1

Let us analyse each option.

Option A - As economy is already expanding at steady levels which means that there is adequate demand in the economy and also due to import price reduction some of the benefits will be pass on consumers, which may further boost aggregate demand . Therefore due to adequate demand already in the economy there is no need for government to further increase expenditure and risk inflation in near term.

Hence this option is incorrect.

Option B - This is correct, as it advocates government to keep taxes steady and let GDP to deficit ratio decline, which will then contract fiscal deficit and provide room for government to fight off any negative shock (if it occurs). Also government can borrow in future at same interest rate if it raises taxes and repays debt in next three years, considering this if any negative shock to economy occurs in future and government needs additional funds to boost aggregate demand it need to borrow those with the stringent conditions imposed by the borrowers, so rather than depend upon borrowing it would be advisable to keep reserve of additional money collected from taxes today to have it as reserve.

Option C - As economy is already expanding there is no need to lower tax today to boost aggregate demand. Also due to uncertainity in future government will need some additional money to fight off the negative shocks (if it occurs). Hence this option is incorrect.

Option D - As economy is already expanding at steady levels which means that there is adequate demand in the economy and also due to import price reduction some of the benefits will be pass on consumers, which may further boost aggregate demand . Therefore due to adequate demand already in the economy there is no need for government to further increase expenditure and risk inflation in near term.

Hence this option is incorrect.

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