The imposition of fiscal rules which aim to limit the discretionary capacity of governments to net spend bias fiscal policy towards pro-cyclical responses when private spending is weak.
Answer: True
The answer is True.
The non-government sector spending decisions ultimately determine the budget balance associated with any discretionary fiscal policy.
The budget balance has two conceptual components. First, the part that is associated with the chosen (discretionary) fiscal stance of the government independent of cyclical factors. So this component is chosen by the government.
Second, the cyclical component which refer to the automatic stabilisers that operate in a counter-cyclical fashion. When economic growth is strong, tax revenue improves given it is typically tied to income generation in some way. Further, most governments provide transfer payment relief to workers (unemployment benefits) and this decreases during growth.
In times of economic decline, the automatic stabilisers work in the opposite direction and push the budget balance towards deficit, into deficit, or into a larger deficit. These automatic movements in aggregate demand play an important counter-cyclical attenuating role. So when GDP is declining due to falling aggregate demand, the automatic stabilisers work to add demand (falling taxes and rising welfare payments).
When GDP growth is rising, the automatic stabilisers start to pull demand back as the economy adjusts (rising taxes and falling welfare payments).
The cyclical component is not insignificant and if the swings in private spending are significant then there will be significant swings in the budget balance.
The importance of this component is that the government cannot reliably target a particular deficit outcome with any certainty. This is why adherence to fiscal rules are fraught and normally lead to pro-cyclical fiscal policy which is usually undesirable, especially when the economy is in recession.
The budget outcome is thus considered to be endogenous - that is, it is determined by private spending (saving) decisions. The government can set its discretionary net spending at some target to target a particular budget deficit outcome but it cannot control private spending fluctuations which will ultimately determine the final actual budget balance.
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