Fiscal stance, structural deficits and policy lags
A bigger deficit (or smaller surplus) signals expansionary policy; a smaller deficit signals contractionary policy. But recessions widen deficits on their own, so judge the stance by the structural deficit, the one that would exist at full employment. Recognition, action and impact lags make timing hard.
Before this: Fiscal policy tools and the fiscal multiplier
On the exam
- Explain the implementation of fiscal policy and difficulties of implementation as well as whether a fiscal policy is expansionary or contractionary
Explain how fiscal policy is carried out, why it is hard to do well, and whether a given policy is expansionary or contractionary. Expect a stance item, a structural deficit calculation and a question on which lag is which.
How deeply to learn each part
- Know the idea
- Understand it in general. It frames other topics, but you will not calculate with it.
- Use it
- Understand it well enough to solve a question with it. Recognize when it applies.
- Memorize
- Learn it by heart. The exam will not give it to you.
You know this one. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still do.
You tested strong here. The full lesson is folded away. The takeaways, formulas and checkpoint below are your quick refresher, and the checkpoint is a fair test of whether you still know it.
Is a fiscal policy expansionary or contractionary?
The fiscal stance is the direction in which the government is pushing demand. The rule is simple: expansionary fiscal policy is a rise in the budget deficit (or fall in the surplus), and contractionary fiscal policy is a fall in the deficit (or rise in the surplus). Watch the change, not the level.
- Expansionary Memorize deficit up or surplus down: spend more, tax less
- Contractionary Memorize deficit down or surplus up: spend less, tax more
- Neutral Memorize no net change, e.g. a pay-as-you-go rule
A positive is expansionary and a negative one contractionary. Spending alone does not decide it: if taxes rise by more than spending, policy is contractionary. A pay-as-you-go rule, which offsets every tax cut or new program, leaves the deficit unchanged and so is neutral.
What is the structural budget deficit?
Memorize
The actual deficit changes for reasons that have nothing to do with policy. In a recession, automatic stabilizers cut tax revenue and raise benefit payments, so the deficit widens on its own. Someone looking only at the headline could conclude that policy has been loosened and no more action is needed.
Economists therefore look at the structural budget deficit (also called the cyclically adjusted deficit): the deficit that would exist if the economy were at full employment. At full employment tax revenue would be higher and transfers lower.
Try this 0 of 3
- Set year 2's actual balance equal to year 1's, but make year 2 expansionary
- Set any year to the asked-as example: actual deficit 6.4% with a cyclical part of 2.3%
- Step through all three policy lags
- Actual balance
- Structural (cyclically adjusted)
| Year | Actual | Cyclical | Structural |
|---|---|---|---|
| 1base year | −3.5 | 0.0 | −3.5 |
| 2neutral | −4.5 | −1.0 | −3.5 |
| 3neutral | −6.0 | −2.5 | −3.5 |
| 4neutral | −5.0 | −1.5 | −3.5 |
| 5neutral | −4.0 | −0.5 | −3.5 |
Stance: neutral. The actual balance moved −0.5 points between years 1 and 5, all of it the cycle at work. The structural balance stayed at deficit 3.5% of GDP: no discretionary change.
Recognition lag. Time to see that the economy has changed. Data arrive late and are revised. Example: A slowdown that began in quarter 0 is only confirmed two quarters in, in quarter 2.
Show working
Cyclical part = budget response × output gap = 0.5 × −5.0 = −2.50% of GDP
Structural balance = actual − cyclical = −6.0 − (−2.50) = −3.50% of GDP
In deficit terms: structural deficit = 6 − 0.5 × 5 = 3.5% of GDP.
Stance: change in the structural balance from year 1 to year 5 = −3.50 − (−3.50) = 0.00 points, so neutral. A fall (a bigger structural deficit) is expansionary.
- 6−(0.5×5)=3.5, the structural deficit in year 3 (% of GDP)
- 6ENTER0.5ENTER5×−3.5, the structural deficit in year 3 (% of GDP)
ENTER enter (on the HP, puts the number on the stack)
Here is the actual deficit and the cyclical part, the amount that arises because output is below potential, all as a share of GDP.
An actual deficit of 6.00% of GDP includes 2.50% of GDP caused by output below potential. The structural deficit is closest to (% of GDP):
6.00% − 2.50% = 3.50%
Structural deficit, % of GDP3.50%
- 6−2.5=3.5
- 6ENTER2.5−3.5
ENTER enter (on the HP, puts the number on the stack)
Exam tip Actual deficit up in a recession: ask how much is cyclical. Only a change in the structural deficit shows what the government chose.
Go deeper Inflation distorts the headline deficit too
Know the idea
National accounts count cash interest on the debt as spending. But inflation erodes the real value of the debt, so only the real interest payment is a true cost. Subtracting inflation times the debt from the headline deficit gives an inflation-adjusted deficit. This is why the actual deficit can mislead when inflation is high.
With debt of 800, inflation of 3% and a deficit of 50, inflation erodes 24 of the debt, so the real deficit is 50 − 24 = 26.
- 800×0.03=+|-+50= 26
+|- change sign
- 800ENTER0.03×CHS50+ 26
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Why can’t fiscal policy fine-tune demand?
Memorize
Fiscal policy cannot stabilize aggregate demand completely, because the difficulties of carrying it out can never be fully overcome.
| Lag | Meaning | Example |
|---|---|---|
| Recognition lag | time to see that the economy has changed (data arrive late and are revised) | a slowdown confirmed two quarters in |
| Action lag | time to decide and put the measure in place | a stimulus bill passed and payments set up |
| Impact lag | time for the measure to affect the economy | a rail program employing people a year later |
The recognition lag has been likened to driving while looking in the rear-view mirror. The same lags affect discretionary monetary policy.
- Policy lags Memorize
- Recognition lag seeing that the economy has changed
- Action lag deciding and implementing
- Impact lag the measure working through the economy
-
- Uncertainty
- Forecasting models are imprecise
- Other demand shifts at the same time
- Private behavior reacts to announcements
-
- Wider limits
- Full employment is hard to measure
- Supply-side slack: more demand just raises inflation
- Large deficit: markets and politics resist
- Crowding out
-
Other difficulties follow.
- Uncertainty. Forecasting models have a poor record. Investment or exports may change at the same time as the stimulus. Private spending also shifts when a policy is announced.
- Inflation. Pushing demand toward full employment tightens labor markets and raises wages and prices, so policy makers hesitate to fine-tune.
- A large existing deficit. Financial markets may refuse more borrowing, so interest rates on government debt rise and political pressure builds to tackle the deficit.
- Measuring full employment. The full-employment level changes as capacity and willingness to work change, and it is hard to measure.
- Supply, not demand. If unused resources reflect a shortage of labor or other inputs rather than weak demand, extra demand is ineffective and raises inflation.
- Crowding out. Government borrowing may compete for limited savings, raising the cost of borrowing and canceling profitable private projects. This remains an empirical debate.
Go deeper Automatic stabilizers and the multiplier
Automatic stabilizers act with no lag and no decision. They are fiscal stimulus built in: as output falls, net tax revenue falls and benefits rise. This lowers the effective multiplier and damps the output response to whatever caused the fall in the first place.
Go deeper Why markets may punish more stimulus
When debt is already high, lenders may see further deficits as a threat to solvency. Yields on government debt rise, which can offset the stimulus. This is the link to sovereign credit analysis in Fixed Income.
Memorize this
MemorizeStance rules
| Change | Stance |
|---|---|
| Deficit rises (or surplus falls) | Expansionary |
| Deficit falls (or surplus rises) | Contractionary |
| No net change (pay-as-you-go) | Neutral |
Memory hook Net effect on the deficit decides it, not spending alone: spending up with a bigger tax rise is contractionary.
Know it cold Structural deficit = actual deficit − cyclical part. Judge discretionary stance by the structural deficit.
MemorizeThe three lags
| Lag | Meaning | Example |
|---|---|---|
| Recognition | Seeing the economy has changed | Slowdown confirmed two quarters in |
| Action | Deciding and putting the measure in place | Stimulus bill passed, payments set up |
| Impact | Time for the measure to affect the economy | Rail program employs people a year later |
Memory hook See it, do it, feel it: recognition, action, impact.
Know it cold Monetary policy suffers from the same lags.
- Expansionary Memorize deficit up or surplus down: spend more, tax less
- Contractionary Memorize deficit down or surplus up: spend less, tax more
- Neutral Memorize no net change, e.g. a pay-as-you-go rule
- Policy lags Memorize
- Recognition lag seeing that the economy has changed
- Action lag deciding and implementing
- Impact lag the measure working through the economy
-
- Uncertainty
- Forecasting models are imprecise
- Other demand shifts at the same time
- Private behavior reacts to announcements
-
- Wider limits
- Full employment is hard to measure
- Supply-side slack: more demand just raises inflation
- Large deficit: markets and politics resist
- Crowding out
-
Quick example
Spending on goods and services rises by 1% of GDP, transfers are unchanged, taxes rise by 3% of GDP. ΔD = 1 + 0 − 3 = −2% of GDP: the deficit shrinks, so policy is contractionary.
- 1−3= −2, contractionary
- 1ENTER3− −2, contractionary
ENTER enter (on the HP, puts the number on the stack)
Quick example
The actual deficit is 4.5% of GDP, of which 1.2% of GDP is cyclical. S = 4.5 − 1.2 = 3.3% of GDP.
- 4.5−1.2= 3.3
- 4.5ENTER1.2− 3.3
ENTER enter (on the HP, puts the number on the stack)
Quick example
Debt is 800, inflation is 3% and the deficit is 50. Inflation erodes 0.03 × 800 = 24 of the debt, so the real deficit is 50 − 24 = 26.
- 800×0.03=+|-+50= 26
+|- change sign
- 800ENTER0.03×CHS50+ 26
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
How it is asked
-
Net stance
A government cuts spending by 1% of GDP and cuts taxes by 2% of GDP.
Deficit widens by 1% of GDP: expansionary. Watch the net change.
-
Compute the structural deficit
Actual deficit 6.4% of GDP; stabilizers account for 2.3% of GDP.
6.4 − 2.3 = 4.1%. Adding gives the trap 8.7; 2.3 is only the cyclical part.
-
Which lag?
Data are late and revised, so ministers accept a slump a year after it began.
Recognition lag. Deciding and implementing is the action lag; the effect arriving is the impact lag.
-
Recession and the deficit
The actual deficit widens in a recession while the structural deficit is unchanged.
Discretionary stance is neutral. The widening is automatic.
Exam traps
- Saying an increase in government spending is always expansionary. A bigger tax rise makes policy contractionary.
- Reading a recession-driven rise in the actual deficit as a discretionary loosening.
- Confusing the action lag (implementing) with the impact lag (effect on the economy).
- Adding the cyclical part to the actual deficit instead of subtracting it.
Checkpoint
5 exam-style questions. About 90 seconds each.
1A government cuts spending by 1% of GDP and cuts taxes by 2% of GDP. Its fiscal policy has become:
2Data showing a slump are published late and revised twice, so ministers accept that the economy has slowed only a year after it began. This delay is the:
3A country's actual deficit is 5.2% of GDP. Automatic stabilizers account for 1.8% of GDP of it because output is below potential. The structural deficit is closest to:
4Last year a government's deficit was 3.0% of GDP, of which 0.6% of GDP was cyclical. This year the deficit is 4.6% of GDP, of which 2.2% of GDP is cyclical because output fell. Discretionary fiscal policy this year is best described as:
5Officials accepted that the economy had slowed in March. The legislature passed a stimulus bill and the agencies set up the payments by October. The delay from March to October is the:
Key takeaways
- A rising deficit is expansionary; a falling deficit is contractionary. Watch the change.
- Use the structural (full-employment) deficit to judge discretionary stance.
- Recognition, action and impact lags make timing hard.
- Uncertainty, supply limits and crowding out further limit fiscal fine-tuning.
Quick example
Spending on goods and services rises by 1% of GDP, transfers are unchanged, taxes rise by 3% of GDP. ΔD = 1 + 0 − 3 = −2% of GDP: the deficit shrinks, so policy is contractionary.
- 1−3= −2, contractionary
- 1ENTER3− −2, contractionary
ENTER enter (on the HP, puts the number on the stack)
Quick example
The actual deficit is 4.5% of GDP, of which 1.2% of GDP is cyclical. S = 4.5 − 1.2 = 3.3% of GDP.
- 4.5−1.2= 3.3
- 4.5ENTER1.2− 3.3
ENTER enter (on the HP, puts the number on the stack)
Quick example
Debt is 800, inflation is 3% and the deficit is 50. Inflation erodes 0.03 × 800 = 24 of the debt, so the real deficit is 50 − 24 = 26.
- 800×0.03=+|-+50= 26
+|- change sign
- 800ENTER0.03×CHS50+ 26
ENTER enter (on the HP, puts the number on the stack) · CHS change sign
Questions about this lesson?
Where this comes back
- Monetary Policy Economics
- How monetary and fiscal policy interact Monetary Policy
- Credit Analysis for Government Issuers Fixed Income
- Introduction to Geopolitics Economics
Questions candidates ask
What is a structural budget deficit?
It is the deficit that would exist if the economy were at full employment, also called the cyclically adjusted deficit. It removes the part of the actual deficit caused by the cycle, such as lower tax revenue and higher benefits in a recession, to show what the government chose.
What are the lags in fiscal policy?
The recognition lag is the time to see that the economy has changed. The action lag is the time to decide on a measure and put it in place. The impact lag is the time for the measure to affect the economy. Together they make timing hard.
How do you know if fiscal policy is expansionary or contractionary?
Look at the change in the budget, ideally the structural budget. A rising deficit or falling surplus is expansionary; a falling deficit or rising surplus is contractionary. Spending alone does not decide it, because taxes can move the other way.
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