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Evaluate Whether Achieving A Budget Surplus Is A Desirable Objective Of Economic Policy.

A model answer for a classic question on macroeconomic policy

Date : 22/05/2020

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Gavin

Uploaded by : Gavin
Uploaded on : 22/05/2020
Subject : Economics

Evaluate whether achieving a budget surplus is a desirable objective of economic policy.

A budget surplus occurs when taxation receipts (T) are higher than government spending (G) during a time period, for example a year or over the course of an economic cycle. An objective is desirable if it is consistent with objectives such as stable, non-inflationary growth and high employment.

On the one hand, achieving a budget surplus is desirable. A surplus means that the National Debt (sum of all previous budget deficits minus any budget surpluses) can be reduced over time. This means that the opportunity cost of funding debt-interest repayments is reduced. In time, this could mean that greater levels of government spending can be directed towards education and healthcare, both of which would be expected to promote higher levels of productivity and stable economic growth in the long term.

The extent to which this is important depends upon factors such as how the surplus is achieved. If it is achieved by reducing government spending on healthcare and education then the process might be harmful to the long-term prospects of the economy, so not desirable. This is because the reduction in expenditure on these areas may increase unit labour costs over time as human capital erodes. If the reduction in the deficit is achieved by increasing corporation tax, the effect would be to increase the costs facing firms, reduce their profit levels and, again, suppress investment. As this diagram shows, the effect on the macroeconomy would be harmful:

Diagram, LRAS and SRAS shift left, explain it fully, referring to the diagram.

The effect of a left shift of SRAS and LRAS would depend on the initial proximity of the economy to full employment as this diagram shows:

Diagram, economy close to Yfe and one with a negative output gap, explain what s happening

If the government introduces an austerity campaign and / or increases taxation at a time when the economy faces a negative output gap, the effect on growth would be much more harmful than if the economy was initially at full employment output.

The extent to which achieving a neutral budget position is desirable depends on the time period considered. Few would argue that, during a recession, achieving a neutral budget position should be the main priority. Instead, it could be argued that the government should increase expenditure and reduce taxes to stimulate aggregate demand as this diagram shows:

Diagram, AD right from a negative output gap. Explain it carefully.

Even in this situation though, the extent to which an increase in G and worsening of the budget position would stimulate AD depends on many factors, for example the size of the multiplier which in turn depends on factors such as the level of confidence in the economy. It also depends on how the additional expenditure is directed if the government spends on imports then there would be no beneficial effect. If it invests directly in stimulating domestic demand, for example by recruiting new teachers and nurses, then the effect would be more significant.

It could be concluded that the fiscal budget should be in a neutral position over the course of an economic cycle budget surpluses achieved during periods of growth above the long term trend rate should be used to eradicate deficits resulting from periods of low growth. Whilst this seems reasonable, it could still be argued that government spending on long-term investment projects should be excluded from the calculations projects such as HS2 would be likely to generate benefits over fifty years or more so it seems unreasonable to count the cost of them over the course of one economic cycle. Then again though, this approach may encourage profligate government investment expenditure which could lead to undesirable consequences such as an increase in the national debt and level of interest payments required to service that debt.

On balance, the case for achieving a neutral budget position is not proven. There are certainly times, such as when the economy is in recession, where a more relaxed fiscal position is probably desirable. Over the course of the economic cycle it seems reasonable to target a neutral budget position but, even then, special treatment of government expenditure on long term investment projects should probably be considered.


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