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How New Zealand Governments Determine Their Fiscal Strategies - A Layman's Guide

2.2 What is happening in the broader economy, and how might the fiscal strategy affect it?

Determining a prudent level of government debt is part of deciding a fiscal strategy, but it is only a starting point. Governments also need to consider the economic cycle and the implications for how fiscal policy should operate.

On average over time, current expenses should not exceed current revenue. But we would not expect exact balancing each year.

In a downturn, it is reasonable for expenses to exceed revenue, in order to compensate for depressed tax revenue and to allow for some temporarily higher expenses, like spending to support people who have lost jobs.

Conversely, in an upturn, we would expect revenue to exceed expenses. Excess revenue can be used to pay down public debt and build up other financial buffers. Paying down government debt when times are good means that debt can rise when times are bad; the country can manage a temporary period of expenses exceeding revenue with no lasting ill effects.

There are other reasons why fiscal policy should generally be tighter in an upturn and looser in a downturn.

For example, looser fiscal policy during an upturn, when the economy is already operating at or near capacity, will further stimulate demand, prompting the Reserve Bank to increase interest rates further. This will put more upward pressure on the exchange rate than would otherwise be the case, and hurt the competitiveness of our exporters. Economists refer to the relative looseness and tightness of fiscal and monetary policy as the "macroeconomic mix". In general, during an economic upturn, tighter fiscal policy (larger surpluses) and looser monetary policy (lower interest rates) is a better macroeconomic mix than the reverse. Even though the economic growth rate may be similar in either scenario, the composition of output will be different. Economic downturns are a better time for loosening fiscal policy (eg, by raising spending or lowering taxes) as the magnitude of interest rate and exchange rate cycles would not be exacerbated.

Governments often come under pressure during upturns to spend more money or cut taxes due to the appearance of large surpluses. At the time it is happening, an unusually strong period of economic growth can look permanent, making it seem harder to justify maintaining large fiscal surpluses. However, it is important that governments resist this pressure to spend surpluses during economic upturns, both for reasons of enhancing exporter competitiveness - as discussed above - and so that the government is better placed to respond to the next downturn, when it comes.

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