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OLS-UKZN-VT-P a r t 4 Economics102

Part 4

Fiscal, Monetary and Trade Policy

A government's course of action is referred to as government policy. While policy is a blanket

term for almost anything that the government may do, there are different types of government
policies. In this part of the course, we use the macroeconomic models studied thus far to study
three types of government policy: fiscal policy, monetary policy and trade policy. Accordingly,
this part is compartmentalised into three sections, each focusing on a particular policy.

Fiscal policy is the use of government expenditure and revenue collection (usually through
taxation) to influence the course of the domestic economy. By changing taxes, government
can effectively change the amount of disposable income available to its taxpayers. For
example, if taxes were to increase, consumers would have less disposable income and in turn
would have less money to spend on goods and services. This difference in disposable income
would go to the government instead of going to consumers. Alternatively, government could
choose to increase its spending by directly purchasing goods and services from private
companies. This would increase the flow of money through the economy and would eventually
increase the disposable income available to consumers. Unfortunately, this process takes
time, as the money needs to wind its way through the economy (the multiplier effect),
creating a significant lag between the implementation of fiscal policy and its effect on the
economy.

Monetary policy can also influence the economy, and is initiated by the central bank to
control the supply of money, and in turn the rate of inflation, within the economy. By
impacting the effective cost of money (via interest rates), the central bank can affect the
amount of money that is spent by consumers and businesses.

Another important element of economic policy-making critical to successful development is

trade policy. Modern trade policy affects not only the international movement of goods and
services, but also how domestic regulations are designed and administered.

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An Introduction to Fiscal Policy:

Reading:
Parkin (3rd ed) Chapter: 30 pp 727-731
National Treasury: SA Budget Highlights 2021
& Budget Review 2021

Key Issues:

 National budget: is an annual statement of the expenditures and revenues of the SA

government
 National budget has two purposes:
 To finance national government programmes and activities (See SA budget
2021 highlights breakdown) and
 To achieve macroeconomic objectives
 Fiscal policy: The use of the national budget ( Gov spending (G) & Taxes (T) ) to
achieve macroeconomic objectives (full employment, economic growth & price stability).
 The role of the minister of finance and parliament:
The Minister of Finance proposes a budget to Parliament in February and, after
Parliament has passed the budget acts in March, the President signs the budget acts
into law. During the fiscal year (1st April to 31st March - next calendar year), Parliament
might pass supplementary budget laws. The budget outcome is calculated after the end
of the fiscal year.

 Highlights of the 2021/2022 budget (T-G):

 Tax revenues of the SA government (See SA budget 2021 highlights). Note the
major tax receipts: Personal income tax, Value Added Tax, Corporate tax and
Customs and excise duties
 Government expenditures (See SA budget 2021 highlights). Note the major
government spending: Learning and Culture, Social Development and Health

 Budget Deficit in historical perspective:

 The South African government has, except for 2007 and 2008, consistently
recorded deficits on the budget.
 As a result of the COVID-19 pandemic, the 2020/21 budget deficit
increased by R235.4 billion relative to the 2020 Budget estimate.

 Surplus/ deficit/balance:
Budget balance = (Revenues – Expenditures)
• If revenues > expenditures, the government has a budget surplus
• If expenditures > revenues, the government has a budget deficit
If revenues = expenditures, the government has a balanced budget

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 Budget balance and Debt: Much government expenditure is on public assets that
yield a return such as highways, public schools and universities and the stock of
national defence capital all yield a social rate of return that probably far exceeds the
interest rate the government pays on its debt.
 The budget balance—the deficit/ surplus—amount that gov borrows or pays back during
a given year.

 The debt—the amount owed by the government—amount gov has borrowed

 Total Government sector: includes provincial and local governments as well as the
national government — the combination of national, provincial and local government
revenues, expenditures and budget deficits that influences the economy.

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Supply-Side Effects of Fiscal Policy

Reading: Parkin (3rd ed) Chapter: 30 pp 732-734

Fiscal policy has important effects on employment, potential GDP, and aggregate supply—called
supply-side effects.

Full Employment and Potential GDP

• Potential GDP is the real GDP that the full employment quantity of labour produces

The Effects of the Income Tax

• The tax on labour income influences potential GDP and aggregate supply by changing the full
employment quantity of labour
• The income tax weakens the incentive to work and drives a wedge between the take-home
wage of workers and the cost of labour to firms
• The result is a smaller quantity of labour and a lower potential GDP

Full Employment and Potential GDP and Taxation

 Refer Figure 30.4 a and 30.4 b:
Equilibrium employment: is full employment and the real GDP produced by the full-
employment quantity of labor is potential GDP. Without tax equilibrium is at the
intersection of LS and LD.

Effects of an income tax in the labour market:

 The introduction of a tax causes the LS curve to shift left (LS+tax). Supply of labor
decreases /the willingness to work decreases with a tax.

 Note: At the new equilibrium (LS+ tax and LD intersection) tax wage rate is higher and
working hours are lower.

 Note: The vertical distance between LS+tax and LS is the value of the tax.

 Note: The difference between the before-tax and after-tax wage rates is the tax wedge
as illustrated in Figure 30.4a.

 Note: The introduction of the tax which decreases the willingness to work/working
hours impacts negatively on potential GDP which therefore declines as illustrated by
a movement along PF in Figure 30.4b.

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Taxation on Expenditure:

 Taxes on consumption expenditure adds to the tax wedge?

This so, because they raise the prices paid for consumption goods and services and are
equivalent to a cut in the real wage rate.

Tax on Capital Income and the Incentive to Save and Invest:

 A tax on capital income lowers the quantity of saving and investment and
Reduces the growth rate of real GDP.

• The quantity of investment and borrowing that firms plan to undertake depends on how
productive capital is and what it costs – its real interest rate!

 A tax decreases the supply of loanable funds: Impact on Investment and saving?

• A tax on interest income weakens the incentive to save and lend and decreases the
supply of loanable funds - Investment and saving decrease
• With less investment, the real GDP growth decreases

 A tax wedge is driven between the real interest rate and the real after-tax interest rate
(see Fig 30.5).

 Figure 30.5: The demand for loanable funds and investment demand curve is DLF and
the supply of loanable funds and saving supply curve is SLF. With no tax, the real
interest rate is 3 % and investment is R200bn,

Tax Impact: Supply curve shifts left (SLF+tax).

 Interest rate impact? the after tax interest rate impact?

Interest rate rises to 4%, the after tax interest rate falls to 1% and investment decreases to
R180 bn. With less investment, the real GDP growth decreases. A tax wedge is driven
between the real interest rate and the real after-tax interest rate !

 With less investment, the real GDP growth decreases. Note: the tax wedge !.

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Laffer Curve:

What does the Laffer curve (Fig above) shows in relationship?

• Relationship betw the tax rate & the amount of tax revenue collected
 At the tax rate T*, tax revenue is Maximised.
 For a tax rate below T*, a rise in the tax rate increases tax revenue.
 For a tax rate above T*, a rise in the tax rate decreases tax revenue.

Demand-side Effects of Fiscal Policy: Automatic vs Discretionary Policy

Reading: Parkin (3rd ed) Chapter 30: pp 735- 739

Key Issues:


Fiscal stimulus: A fiscal stimulus is the use of fiscal policy to increase production
and employment. Fiscal stimulus can be either
 Automatic
 Discretionary
Automatic fiscal policy is a fiscal policy action triggered by the state of the economy with
no government action.

Discretionary fiscal policy is a policy action that is initiated by an act of Parliament.

Automatic Fiscal Policy and Cyclical and Structural Budget Balances

Two items in the government budget change automatically in response to the state of the
economy.
 Tax revenues
 Needs-tested spending

Changes in Tax Revenues

• What happen if the economy is in a recession? Impact on Wages and profits and tax?

• Real GDP less in a recession, wages & profits less & Tax revenues Lower!

Needs-Tested Spending
• What happen if the economy is in a recession? Impact on unemployment?

• If the economy is in a recession, unemployment rises and the number of people

experiencing economic hardship increases, so needs-tested spending increases (&vice
versa in a boom)

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Automatic Stimulus
• In a recession, revenues fall and expenditure increase. So the budget provides an
automatic stimulus that helps to shrink the recessionary gap (& vice versa in a boom)

Fiscal Stimulus: Discretionary fiscal stabilisation/ fiscal policy and Aggregate Demand (AD)

 Most discretionary fiscal stimulus focuses on its effects on AD. Changes in government
expenditure and taxes change AD and have multiplier effects. Two main fiscal
multipliers:

 Government expenditure multiplier: is the quantitative effect of a change in

government expenditure on real GDP. An increase in government expenditure
increases real GDP. With a rise in real GDP income rises and consumption
expenditure increases & AD increases. If this were the only consequence of the
increase in government expenditure, the multiplier would be >1.

 Tax multiplier: is the quantitative effect of a change in taxes on AD. If we

have a decrease in tax, the demand-side effects of a tax cut are likely to be
smaller than an equivalent increase in government expenditure.

Graphical Illustration of Fiscal Stimulus

• Figure 30.8 shows how fiscal stimulus is supposed to work if it well executed,
Potential GDP is R4 trillion and real GDP is R3 trillion (R1 trillion recessionary
gap). An increase in G and a decrease in tax (T) increase aggregate
expenditure.
• The multiplier increases aggregate demand (AD shift right to AD1). Price
increases to 115; real GDP increases to R4 trillion and the recessionary gap is
eliminated.

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Fiscal stimulus actions are also seriously hampered by Time Lags: There are three possible
time lags:
• Recognition Lag: The recognition lag is the time it takes to figure out that
fiscal policy actions are needed

• Law-making Lag: The law-making lag is the time it takes Parliament to pass the laws
needed to change taxes or spending

• Impact Lag : The impact lag is the time it takes from passing a tax or spending change to its
effects on real GDP being felt

Monetary Policy Objectives and Framework

Reading: Parkin (3rd ed) Chapter 31: pp 746-749

SARB Monetary Policy Committee Statement January 2021

Monetary policy
• Monetary policy objective: The primary objective of South Africa’s monetary policy is to
control inflation (achieve and maintain price stability & paying close attention to CPI). The
South African Reserve Bank (SARB) is the central bank of South Africa and its central
monetary authority. Since 2000, South Africa has used an inflation targeting strategy. –
The central bank makes a public commitment to:
1. Achieve an explicit inflation target - Inflation targets are specified in terms
of a range for the CPI inflation rate (an avg inflation rate determined)
2. State how its policy actions and instruments will achieve that target – (a)
state clearly and publicly the goals of monetary policy; (b) establish a
framework of accountability; and (c) keep the inflation rate low and stable while
maintaining a high and stable level of employment

Monetary Policy Instruments:

The Repo Rate and the Refinancing System:
• The cost at which the banks obtain liquidity from the Reserve Bank is referred to as the
repurchase rate, or simply the repo rate
• The refinancing system refers to the way in which a central bank extends credit to banks
that are short of cash reserves

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The Reserve Bank uses other instruments:

• Cash reserve requirements for banks: Compels banks to keep a certain % of their
deposits in an account at the central bank. If a bank experiences an increase in its
deposits, it is also required to keep more reserves
• Open-market operations: The SARB buys or sells government securities
(government bonds and Treasury bills) from or to a commercial bank or the public

SARB’s decision making strategy:

 The inflation rate: The Reserve Bank forecasts of the inflation rate are a
crucial ingredient in its interest rate decision – affects raising and lowering of
the repo rate

 The output gap: The Reserve Bank also monitors and forecasts real and
potential GDP and the gap between them, the output gap. If the output gap is
positive, an inflationary gap, the inflation rate will most likely accelerate, so a
higher interest rate might be required. If the output gap is negative, a
recessionary gap, the inflation might ease, leaving room to lower the interest rate

 Watch the video - the SARB Governor Lesetja Kganyago on Inflation & Monetary
policy viewpoints.

Monetary Policy Transmission Mechanisms

Reading: Parking (3rd ed) Chapter 31: pp 750-755

Key Issues:

Transmission Channels: The Reserve Bank identifies several channels through which a change
in the repo rate influences AD and subsequently inflation in the economy (See FIG 31.4):

Bank Credit Channel

• As soon as the Monetary Policy Committee (MPC) announces a new setting for the repo
rate, the cost of funds for banks changes and therefore banks adjust their lending rates
Interest Rate Channel
• The monetary policy decision taken by the MPC represents a change in the repo rate.
Since the repo rate changes, it also affects other interest rates in the economy
Exchange Rate Channel
• The exchange rate responds to changes in the interest rate in South Africa relative to the
interest rates in other countries – the South African interest rate differential
Note: If the SARB lowers the repo rate, short-term interest rates and lending rates fall, and
the rand depreciates. The weaker exchange rate makes SA exports cheaper and imports
more costly.
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Can the Reserve Bank Fights Recession: Use Expansionary Monetary Policy

• See FIG 31.7

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Can the Reserve Bank Fights Inflation: Use Contractionary Monetary Policy
• FIG 31.8

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Introduction to International Trade: Reading: Parkin (3rd Ed) Chapter 7 pp149-153

Key Issues:

There is compelling evidence that countries that have successfully integrated into the global
economy have achieved stronger and sustained growth and development than countries that
have not integrated. Therefore, having a basic understanding of how trade responds to
government policy is fundamental to developing effective policies and providing good public
administration. As an open economy there is a need to trade (Imports - we buy from people
in other countries and Export – we sell to people in other countries).

What Drives International Trade?

• Comparative advantage is the fundamental force that drives international trade
• Comparative advantage is a situation in which a person can perform an activity or produce a
good or service at a lower opportunity cost than anyone else
• National comparative advantage is a situation in which a nation can perform an activity or
produce a good or service at a lower opportunity cost than any other nation
• The basis for comparative advantage is divergent opportunity costs between countries.
• If the opportunity cost of producing a T-shirt is lower in Bangladesh than in SA, so
Bangladesh has a comparative advantage in producing T-shirts.
Gains from trade? Both countries can reap gains from trade by specializing in the production of
the good in which they have a comparative advantage and trade.

Case: US T-SHIRT MARKET – EFFECTS OF TRADE WITH IMPORTS

With free trade (more competition), the price of a T-shirt in US falls to $5:
 At $5 a T-shirt, US garment makers willingness to produce is
less and cut production to 20 million T-shirts a year.
 At $5 a T-shirt (now cheaper), Americans willing to buy 60 million T-shirts a year.
 Shortage in the market: 40 million T-shirts
 With Free Trade: US imports 40 million T-shirts a year.
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Case: SA WINE MARKET – EFFECTS OF TRADE WITH EXPORT

Trade effects in SA Wine exports (Fig 7.4): With International trade the price increases to
world/international price (from R100 to R150). Sellers of exported goods benefit from higher
pricesProducer surplus increases/expands & Consumer surplus decreases/shrinks.

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Trading with the world & International Trade Restrictions: Reading: Parking (3rd ed) Chap
7, pp 167-169 & Chapter 7, pp 154-164 & US- China Trade War: BBC News, 29 June 2019

Key Issues:
SA US
GD X 2 hrs 1 hr
GD Y 1hr 3 hrs
Relative Ratio: GD X/GDY 2/1=2 1/3=0.3
Relative Ratio: GDY/GDX 1/2 = 0.5 3/1 =3

 Absolute advantage (Adam Smith theory)? US in producing GD X and SA in producing

GD Y
 Comparative advantage and Direction of Trade? Based on the relative ratio (lower
opportunity cost), US cheaper at producing GD X will produce and export GD X. SA
cheaper at producing GD Y will produce and export GD Y

SA US
GD X 1 hr 2 hr
GD Y 1hr 3 hrs
Relative Ratio: GD X/GDY 1 0.67
Relative Ratio: GDY/GDX 1 1.5

 Absolute advantage? SA in producing both GD X and GD Y

 Comparative advantage (David Ricardo theory) and Direction of Trade? Based on the
relative ratio (lower opportunity cost), US cheaper at producing GD X will produce and
export GD X. SA cheaper at producing GD Y will produce and export GD Y

Governments can use several tools to restrict international trade:

 Tariff: A tariff is a government-imposed tax on imports. With a tariff domestic price
increases. Domestic production increases and the quantity imported decreases. Tariff
duty generates revenue for the government.
 Quota: A quota is a limit on the quantity of a good that can be imported. With an import
quota domestic price increases. The quantity produced locally increases and the
quantity imported decreases.
 Other non-tariff barriers: legal specifics highly restrictive case of health and safety
standard that imports must meet.
 Voluntary export restraints: Voluntary agreement whereby exporters agree to limit the
quantity of their exports.

Despite the fact that free trade promotes prosperity, trade is restricted. There are several
arguments for restricting international trade
 The infant industry argument
 The dumping argument to counteract foreign dumping i.e when exporters sell its
exports at a price below its cost of production
 Saves jobs
 Allows us to compete with cheap foreign labour
 Penalise lax environmental standards
 Protects national culture
 Prevents rich countries from exploiting developing countries
Why is international trade restricted?
 Tariff revenue
 Rent seeking
 Compensate losers

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Governments can use various tools to restrict international trade and protect domestic
industries from foreign competition. Example: Case Tariff

◆ Tariff - a tax imposed by one country on the goods and services imported from another
country

The End- Best Wishes

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