BEO1105 Economic Principles

Topic 11

Macroeconomic Policy II: Fiscal Policy

Reading: Chapter 17, Layton et al.

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KEY CONCEPTS TO BE LEARNT IN THIS TOPIC

• Discretionary fiscal policy• The balanced budget multiplier• Automatic stabilisers• Supply-side fiscal policy• The federal budget• The macroeconomic significance of the budget• Implications of the budget outcome for

government debt levels

Fiscal Policy

– Fiscal Policy: Changes in federal governmentspending and taxes and that are

intended to achieve macroeconomic policy objectives, such as full employment, price stability, and sustainable rates of economic growth.

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Fiscal Policy• Discretionary fiscal policy versus Automatic

stabilisers. Discretionary fiscal policy is used as a counter

cyclical tool. It is the deliberate changes in government spending and/or taxation decisions with the aim of achieving the government’s macro policy objectives such as low inflation and full employment.

Automatic stabilisers: Government spending and taxes that automatically increase or decrease along with the business cycle.

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DISCRETIONARY FISCAL POLICY• Discretionary fiscal policy is the use of

changes in government spending and/or taxes to alter aggregate demand (AD) and stabilise the economy.

• The government can increase AD through expansionary fiscal policy.

• The government can reduce AD through contractionary fiscal policy.

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DISCRETIONARY FISCAL POLICIES

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*Balanced multiplier

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INCREASING GOVERNMENT SPENDING TO COMBAT RECESSION

• In a period of slow economic growth, policy makers could either: – do nothing and wait for the business cycle to

expand, or – increase government spending.

• This expansionary fiscal policy would:– shift the AD curve outwards (to the right)– increase real GDP– raise the price level.

INCREASING GOVERNMENT SPENDING TO COMBAT RECESSION

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THE AMOUNT OF SPENDING REQUIRED

• Initial spending by the government is amplified, as a spending multiplier occurs.– Those receiving the money spend some of it on

goods and services, which creates a ripple effect.• The proportion spent depends on the marginal

propensity to consume (MPC).• We use this to calculate the spending multiplier.

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Marginal Propensity to Consume (MPC)

• Disposable Income (YD) = the income of households plus transfers received from the government less taxes paid to the government.

• Since YD can only be consumed (C) or saved (S): YD = C + S where C = consumption expenditure S = Saving

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Marginal Propensity to Consume (MPC) (continued..)

• Marginal Propensity to consume (MPC) = change in consumption expenditure (ΔC) divided by change in disposable income (ΔYD):

MPC = ΔC / ΔYD• Example:

Then MPC = $7,500 / $10,000 MPC = 0.75

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Period 1 Period 2 Change

Yd $30,000 $40,000 $10,000

C $25,000 $32,500 $7,500

The Spending Multiplier

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Change in Income

MPC Change in Y

Period 2 $10,000 0.75 $7,500

Period 3 $7,500 0.75 $5,625

Period 4 $5,625 0.75 $4,218.75

Period 5

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THE SPENDING MULTIPLIER

THE SPENDING MULTIPLIER• We can use a formula to determine the

spending multiplier:

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The multiplier = 1 – MPC1

The multiplier = 1 – 0.751

The multiplier = 0.251

The multiplier = 4

THE SPENDING MULTIPLIER• If MPC is 0.75, using the formula (1 / 1- MPC), the spending multiplier is 4. • An initial increase in $1 billion government

spending will result in $4 billion extra spending.

• If MPC is 0.8, using the formula, (1 / 1- MPC), the spending multiplier is 5.

• If MPC is 0.85, using the formula, (1 / 1- MPC), the spending multiplier is 6.7.

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CUTTING TAXES TO COMBAT A RECESSION

• Cutting taxes would also expand the economy and help restore full employment.

• This policy would also:– shift the AD curve outwards– increase real GDP– raise the price level.

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THE EFFECT OF A TAX CUT

Maybe Not! There is some debate over the size of multipliers.

Figure 14.6 The multiplier effect and aggregate demand

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USING FISCAL POLICY TO COMBAT INFLATION

• Contractionary fiscal policy can also be effective against demand-pull inflation.

• Cutting spending reduces aggregate demand (a ‘negative’ spending multiplier applies in this case).

• The price level will decrease.

• The government could also raise taxes.

USING FISCAL POLICY TO COMBAT INFLATION (CONT.)

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THE BALANCED BUDGET MULTIPLIER• This refers to an equal change in government

spending and taxes.• This gives a neutral effect (zero-sum) on

government finances – a prudent way of financing government.

• The balanced budget multiplier is equal to 1, and the cumulative change in aggregate demand is always equal to the amount of the initial change in government spending.

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THE BALANCED BUDGET MULTIPLIER (continued)

• Example: Assume a $1 billion increase in government spending and a $1 billon increase in taxes to finance that spending.

• with MPC = 0.75, the spending multiplier is 4. Then, the increase in government spending being $1 billion, the addition to aggregate demand is 4 billion (= $1 billion x 4).

• With increase in taxes of $1 billion, the MPC = 0.75, the direct reduction in consumption is only $ 0.75 billion ($1 billion x 075). The spending multiplier in this case = 4. Thus, the reduction in aggregate demand is $3 billion ($0.75 billion x 4).

Therefore, cumulative increase in aggregate demand is $1 billion ($4 billion - $ 3 billion), which is exactly equal to initial government spending of $1 billion.

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Baby bonus brings a boom for retail spending

The Baby Bonus illustrates the impact government expenditure programs can have on economic activity throughout the Economy.

Further Reading on the Baby Bonus

The the Baby Bonus was introduced in 2004 at $4,000 and increased over the following years to $5,000. The Australian economy was at or near full employment in the mid 2000s. There was a claim that the Baby Bonus precipitated an increase in retail spending. (Follow the link below to find out more about the Baby Bonus).

http://www.babybonus.com.au

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AUTOMATIC STABILISERS

• Government revenues and expenditures automatically change over the course of the business cycle.

• These changes help to stabilise the economy to some extent, without the need for changing government spending too much.

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AUTOMATIC STABILISERS (CONT.)

• Transfer payments (e.g. job search allowance) fall as GDP rises, mainly because unemployment falls.

• On the other hand, tax revenues and GDP are directly related (higher personal and business incomes).

AUTOMATIC STABILISERS

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SUPPLY-SIDE FISCAL POLICY• This reflects government policies that increase

aggregate supply to achieve long-run growth in real output, full employment and a lower inflation level.

• Examples:– microeconomic reform in Australia, e.g. tax

reform, deregulation, Work Choices– the Reagan tax cuts in the USA.

SUPPLY SIDE FISCAL POLICY

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The Limits of using Fiscal Policy to Stabilise the economy

• Timing lags– Recognition lag: the time it takes policy

makers to ascertain there is a problem to be addressed.

– Legislative lag: the time it takes to have policy approved by both Houses of Federal Parliament.

– Implementation lag: the time it takes to implement the policy, and for the policy

to take effect.

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Limits to Fiscal Policy: The Crowding Out Issue

• Crowding out occurs when there is a reduction in private sector spending due to federal budget deficits being financed by government borrowing.

• In order to finance the deficit, the government must compete for funds in the finance market which increases interest rates.

• High rates dissuade private sector spending (or borrowing to invest).

• Crowding out will reduce the impact of expansionary fiscal policy.

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THE FEDERAL BUDGET

• The Australian federal budget (May each year) is the principal fiscal policy statement each year.

• The budget outcome is usually described as being:– in surplus (government revenue exceeds government

spending); or– in deficit (government spending exceeds government

revenue).

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THE BUDGET OUTCOME

• The budget outcome is of interest because:– federal government outlays are a considerable

percentage of GDP– the budget announces the government’s fiscal

stance (whether the government is trying to expand or contract economic activity).

– The Australian Government Budget– The New Zealand Goverment Budget

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Government expenditure as a percentage of GDP, 1960 - 2007

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Japan – countercyclical policy

Government Expenditure

Government expenditure by function, 2007/08

Source: Australian Government (2007), Budget 2007-08, Appendix D, Australian government taxation and spending, viewed 5 May 2008, at www.budget.gov.au. Copyright Commonwealth Government of Australia. Reproduced by permission.

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Government revenue by source, 2007/08

Source: Australian Government (2007), Budget 2007-08, Appendix D, Australian government taxation and spending, viewed 5 May 2008, at www.budget.gov.au. Copyright Commonwealth Government of Australia. Reproduced by permission.

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THE COUNTERCYCLICAL ROLE OF FISCAL POLICY AND THE BUDGET

• The countercyclical role of fiscal policy implies budget deficits in times when economic activity is low (recession) and budget surpluses in times when economic activity is high (boom).

Many governments now place an emphasis on their budgets being ‘in balance’ over the course of the business cycle in order to show that they are responsible and are safe borrowers.

Bar Chart

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OTHER ROLES OF FISCAL POLICY

• The budget also reflects medium-to-long-term goals.

• Recent policy initiatives have included:– the introduction of the GST in 2000, which

broadened the tax base– greater focus on economic growth– focus on reducing the unemployment rate.

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IMPLICATIONS OF THE BUDGET OUTCOME FOR GOVERNMENT DEBT

• Budget deficits add to government debt.– This is the total value of outstanding government

securities.• The Australian government debt to external parties is

relatively low in comparison to OECD figures.• Future budget deficits will need to be financed by

money or debt financing.

GENERAL GOVERNMENT NET DEBT LEVELS

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THE BURDEN OF THE DEBT

• The burden of the debt is the possibility that government debt could create a burden on future generations.

• It should be remembered, however, that much wealth creation involves the use of borrowing and debt.

• Much government debt has also been used to finance infrastructure.

THE EXTERNAL COMPONENT OF NATIONAL DEBT

• The portion of a country’s national debt that is owed to foreigners is a different matter.

• Currently Australia has a negligible component of national debt.

• This is an external debt that should increase the quantity of output from future production, but will also involve repayment with interest to foreigners.

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Commonwealth government budget – surpluses and deficits, Australia, 1974/75 to 2007/08

Source: Australian Government (2007), 2007-08 Budget Overview, Appendix G, Historical budget and net debt data, viewed 5 May 2008, at www.ato.gov.au. Copyright Commonwealth of Australia. Reproduced by permission

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SUMMARY• Discretionary fiscal policy; changes to government spending

and/or taxes

• Expansionary fiscal policy and Contractionary fiscal policy

• Spending multiplier, tax multiplier and balanced budget multiplier

• Timing lags and Crowding out issue

• Automatic stabilisers

• Supply side fiscal policy

• Budget deficit, budget surplus and debt

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Self-Review Questions• What is discretionary fiscal policy? What are automatic

stabilisers?• What type of fiscal policy that the government will

implement in case of a recession? What are the effects of such a fiscal policy on aggregate demand, real GDP an the price level?

• What type of fiscal policy that the government will implement in case of increasing inflation? What are the effects of such a fiscal policy on aggregate demand, real GDP an the price level?

• What are the limits to using discretionary fiscal policy?

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