The objectives of fiscal policyOver the medium term, to ensure sound public finances and that spending and taxation impact fairly within and between generations: andOver the short term, to support monetary and, in particular, to allow the automatic stabilizers to help smooth the path of the economy. (HM Treasry, 2003)The ultimate objectives of fiscal rules are:(1) the financial sustainability of the state, (2) the efficient financing of public spending and (3) macroeconomic stability, that is, the elimination of unnecessary and undesirable fluctuations in economic activity. (Buiter (2003))The reason why a government, HM Treasury, prefer to operate according to a set of fiscal rules instead of using completely discretionary policy.The fiscal year 1988-89, the HM treasury thought that budget surplus was due to cyclical factor. And the government cut the tax rate. But after 1990-91, current budget surplus was changed to deficit deeply.The economy of the UK didn’t recover until 1997-98. This was because incorrect forcast by the government about future economy. We can see the fact at the chart [The Budget Balance fo the UK]. So, HM Treasury feel that fiscal rule is needed to give a room for a government finance when the forecast was fail and to give transparency for the fiscal policy.The UK adopted ‘The Code for Fiscal Stability’ under section 155 of the Finance Act 1998.Chart 1: The Budget Balance of the UK (HM Treasury)The argument for and against active discretionary policy, in terms of policy lags and effectivenessOn the view of traditional Keynesian, discretionary policy impacts directly on current income, under following assumptions : sluggish price or wage adjustment, slack productive capacity, and liquidity-constrained firms and households. When loosening fiscal policy, both consumption and investment are increased so demand and output. It is represented by the so-called IS-LM model and the Mundel-Fleming model.There is a good explanation for the Impact of fiscal policy in the IS-LM and Mundell-Fleming models in the document ‘Fiscal stabilization and EMU’.“A standard tool for analysing the impact of stabilisation policy is the IS-LM model set outby Hicks (1937) in response to Keynes’ General Theory (1936). This model integrates thegoods and money markets, and assumes fixed prices and a closed economy. A fiscal easingpushes up output and increases interest rates.1 The extent of the stimulus to output fromsuch a policy action will then depend on the degree of ‘crowding out’ of private spendingfrom the higher interest rate. The greater the sensitivity of private spending to interestrates and the less sensitive money demand is to interest rates, the larger the amount ofcrowding out”. (HM Treasury, Fiscal stabilization and EMU, 2003)For the open economy extension of the IS-LM model, the Mundell-Fleming model was released. HM Treasury reads, “The effectiveness of fiscal policy can be analysed under both flexible and fixed exchange rates. With flexible exchange rates and some capital mobility, a fiscal easing would initially raise output and interest rates as in the closed economy case. However, given that domestic interest rates had risen relative to foreign interest rates, there would be a capital inflow into the country which would result in an exchange rate appreciation. This would reduce net exports and eventually offset some of the boost to output from the fiscal loosening. In the extreme case of perfect capital mobility, the boost to output would be fully offset by a worsening in the net export position. In this case, fiscal policy would only affect the composition of demand within the economy. Under fixed exchange rates, an easing in fiscal policy will again cause a capital inflow into the country. However, with a fixed exchange rate, the central bank will have to sell its own currency and acquire foreign exchange reserves. This will raise the money supply and further boost output. Thus the Mundell-Fleming model suggests that discretionary fiscal policy will have a larger impact on output under fixed rather than floating exchange rates.” (HM Treasury, Fiscal stabilization and EMU, 2003)In the short term, the theory above is acceptable. But in the longer term, it’s not helpful. The reason why the active discretionary policy might not be effective is as follows:Degree of price flexibility is matter. The greater the degree of wage and price flexibility, the less effective fiscal policy would be in stabilizing the economy.The crowding out effect is another matter. Due to the impact on financial markets, interest rate increase, fiscal policy may not be effective by offsetting declines in private sector expenditure. It’s about the firm’s investment expenditure.‘The Ricardian equivalence’ by Barro(1974) is also problem of traditional view of fiscal policy effect. It’s a theory of how individuals evaluate the future implications of the government’s current financing and how they adjust their spending to take account of it. It’s about the household’s consumption spending. Forward-looking consumers will tend to be little affected by temporary changes in income taxes unless they are subject to liquidity constraints.Empirical studies say that there is no perfect Ricardian equivalence, in other words, consumption smoothing is far from perfect concluded by Mankiw(2000) The same evidence was discovered in US and UK.But counties with high debt-GDP ratios and lacks on fiscal framework credibility, Something close to Ricardian equivalence is observed.The extent to which fiscal policy is effective in reality depends on the instruments and the environment of economy and policy.A change in government expenditure is likely to have a more powerful effect on demand than a change in income taxes when consumers are forward-looking in the short run. But there is significant lags between government expenditure and effect of demand. And this reduces the effectiveness of fiscal policy.The impact of an income tax change on demand will also depend in park on the propensity to consume of the people affected.The monetary regime affect the effectiveness of fiscal policy. For example, I percent demand shock on UK in EMU affect higher than UK outside EMU. Because UK outside EMU is affected by higher interest rate and exchange rate which smooth the fluctuation of output and inflation. That is described in the EMU study ‘Modeling shocks and adjustment mechanisms in EMU’.A country with a high share of imports and small GDP would tent to be ineffective of fiscal policy because of import leakage.Through 1950 to 1970 in the UK history, discretionary fiscal policy was used mainly to control cyclical ups and downs but in vain. After failure of discretionary fiscal policy, UK government made criteria for effective fiscal stabilization.These are as follows:1) Stability through constrained discretion2) Credibility through sound long-term policies3) Credibility through maximum transparency4) Credibility through pre-commitmentBut these criteria are not enough to achieve macroeconomic stability.Symmetrical, forward-looking, basing on clear and transparent operating rules and separating from other government objective institutional framework is needed.And for the effective fiscal stabilization instrument, there are criteria as follows;1) maximize the impact on activity2) minimize inside and outside lags3) avoid any negative impact on economic efficiency and equityAbout the lags, there are two lags. One is inside lags and the other is outside lags.Inside lags are the time delays between recognition of necessity and when the action is implemented.Outside lags are the time delay between when the action is implemented and when the action is transmitted to domestic demand.The case for fiscal rules in the context of coordination between fiscal and monetary policy.The Budget deficit caused by fiscal policy usually financed by borrowing from the market, then the interest rates increase or there would be money supply shortage. In this case, monetary policy should be reacted on this financial situation to be eased.Through the financial market, the fiscal policy and monetary policy is deeply related. So, the coordination between fiscal and monetary policy is needed.The ‘crowding out’ effect is one of the good examples of relationship between fiscal policy and monetary policy, According to the theory of ‘crowding out’ effect, fiscal policy effect could be muted by the private sector decrease of investment through the interest rates increase. If there were appropriate monetary policy for interest rate control along with fiscal policy then the effect of fiscal policy could be more effective.For the coordination between fiscal and monetary policy, there are several arrangements.1) Independence of the central bank. Central bank independence from the political power is usually advocated to reduce the alleged inflationary bias of governments.2) Preventing and resolving conflicts between fiscal policy and monetary policy should be arranged not to prefer short-term consideration under political pressure to long-term consideration3) Limiting direct central bank credit to the government. Excessive central bank credit is likely to pose a threat to macroeconomic stability.4) Balanced budget or deficit limitation clauses.5) Currency board arrangement can enhance credibility.The design of the particular rules adopted by the HM TreasuryThe UK’s budgetary rules are as follows:The golden rule: over the economic cycle, the government will borrow only to invest and not to fund current spending. It is met when, over the economic cycle, the current budget is in balance or surplus; andThe sustainable investment rule: public sector net debt as a proportion of GDP will be held over the economic cycle at a stable and prudent level. Other things equal, a reduction in public sector net debt to below 40 percent of GDP over the economic cycle is desirableThese rules are made by some principles as follows:(1) Transparency in the setting of fiscal policy objectives, the implementation of fiscal policy and in the publication of the public accounts;(2) Stability in the fiscal policy-making process and in the way fiscal policy impacts on the economy;(3) Responsibility in the management of the public finances;(4) Fairness, including between generations; and(5) Efficiency in the design and implementation of fiscal policy and in managing both sides of the public sector balance sheet. (The Code of Fiscal Stability)Does these rules actually satisfy the objectives.Table 1: Meeting the fiscal rules (HM Treasury)If the average surplus on the current budget is equal to or greater than zero, then the golden rule is met. While the current budget was changed into deficit in 2002-03, the average surplus since 1997-98 is positive. So, the UK is meeting the golden rule.The sustainable investment rule requires public sector net debt as a proportion of GDP to be held at a stable and prudent level over the economic cycle. To meet the sustainable investment rule, public sector net debt should be maintained below 40 percent of GDP. Table 1 shows that since 1998-99 net debt has remained below 40 per cent of GDP. So, the government met the sustainable investment rule.Since 2002 most G7 economies have experienced rising debt-to-GDP ratios as publicfinances changed into deficit. Chart 2 shows OECD data on general government netfinancial liabilities for the G7 countries.Since 1997, general government net financial liabilities in the UK have been lower than other G7 economies, and in 2006 remained lower than all the G7 countries except Canada.It means that UK government keeps the fiscal rule, the sustainable investment rule in spite of the general trends of increase on government spending.Chart 2: General government net financial liabilities in G7countries (HM Treasury)While the primary objective of fiscal policy is to ensure sound public finances over themedium term, fiscal policy also plays an important role by supporting monetary policy todeliver economic stability over the cycle.As we can see in Chart 3 below, effect of automatic stabilizers and fiscal stance successfully has been acting as smoother of output gap as one of fiscal objectives, meeting fiscal rules. In 1997-2001, fiscal stance was tightened. In 2001-2005, fiscal stance was eased for economic rebounce.Chart 3: Fiscal policy supporting monetary policy (HM Treasury)In history of UK before the introduction of the macroeconomic framework, it’s not a common thing that public investment grow during fiscal tightening period. Breaking the relationship between borrowing for current spending and for investment is one of the effectiveness of the golden rule. Public sector net investment as a share of GDP is now over three times higher than it was in 1997-98. So, even in the period of budget deficit, net investment can increase. It’s one of the success of adopting fiscal rules.Chart 4 : Current budget deficit and net investmentReferencesDavid Miles and Andrew Scott, Macroeconomics : Understanding the Wealth of Nations, NY : Wiley, second edition, 2005.E Laurens & BG de la Piedra (1998) ‘Coordination Of Moneytary & Fiscal Policies’Feldstein, Martin (1997) ‘The Council of Economic Adviser: From Stabilization to Resource Allocatin’, The American Economic Review, Vol.87, No.2, Papers and Proceedings of the Hundred and Fourth Annual Meeting of the American Economic Assciatin. (May) pp.99-102HM Teasury, ‘End of year fiscal report’ (October 2007)HM Treasury, ‘Fiscal Stabilisation and EMU’HM Treasury, The Stability and Growth Pact : A Discussion Paper, March 2004Hyung-Soo Park, Deockyun Ryu, A Study on Fiscal Rules in Korea, Korea institute of public finance, 2006.The Code for Fiscal Stability, Section 155 of the Finance Act 1998.Willem Buiter (2003), ‘How to Reform the Stability and Growth Pact’