PowerPoint to accompany Chapter 17 Fiscal Policy

PowerPoint

to accompany

Chapter 17

Fiscal Policy

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Learning Objectives

1. Define fiscal policy.

2. Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilise the economy.

3. Explain how the multiplier process works with respect to fiscal policy.


Learning Objectives

4. Discuss the difficulties that can arise in implementing fiscal policy.

5. Explain how the federal budget can serve as an automatic stabiliser.

6. Discuss the long-run effects of fiscal policy.


Stimulus policies bring booms for retailers?

The 2008 and 2009 cash payments given to most people by the federal government were designed to stimulate consumer spending during a time of economic downturn.

Retail spending increased, but critics argued that much was saved, or spent on imported goods.

The Baby Bonus, which began in 2004, is another policy which impacts on retail spending.


Fiscal Policy: Changes in federal taxes and purchases that are intended to achieve

macroeconomic policy objectives, such as full employment, price stability, and healthy rates of economic growth.

Fiscal policy refers to the actions of the federal government, and not state, territory or local governments.

LEARNING OBJECTIVE 1

Fiscal Policy


Automatic stabilisers versus discretionary fiscal policy.

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

Discretionary fiscal policy: When the government is taking actions to change spending or taxes to achieve its economic objectives.


Fiscal Policy


An overview of government spending and taxes.

Government expenditure includes government purchases and government spending.

Between 1960 and 2008, government spending fluctuated between 19% and 25%

as a proportion of GDP.

Government spending as a proportion of GDP is forecast to rise to 29% of GDP by 2009/10.


Fiscal Policy

Government expenditure as a percentage of GDP, 1960–2008: Figure 17.1

Source: Reserve Bank of Australia (2009), Statistics, Gross Domestic Product Expenditure Components, Table G11, viewed 2 June 2009, at <www.rba.gov.au>

15161718192021222324252627282930

1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008

Per

cen

t


Government expenditure as a percentage of GDP, 2007/08 to 2012/13: Figure 17.2

Source: Australian Government (2009), Budget 2009-10, Budget Overview, Appendix A, Australian Government Budget Aggregates, viewed 2 June 2009, at <www.budget.gov.au>

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25

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28

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2007/08 2008/09 2009/10 2010/11 2011/12 2012/13

Per

cen

t



An overview of government spending and taxes.

The largest single source of federal government revenue is from personal income

taxation receipts – almost half of government revenue.


Fiscal Policy

Government revenue by source, 2007/08: Figure 17.3

Source: Australian Government (2007), Budget 2007-08, Appendix D, Australian Government Taxation and Spending, viewed 5 May 2008, at <www.budget.gov.au> Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

http://www.budget.gov.au/


Expansionary fiscal policy: Involves increasing government purchases and/or decreasing taxes.

An increase in government purchases will increase aggregate demand directly.

A reduction in taxes has an indirect effect on aggregate demand through the effect on

disposable income.


Using fiscal policy to influence aggregate demand


Expansionary fiscal policy.

The goal of expansionary fiscal policy is to increase aggregate demand by more than it would have increased without policy.

The aim is to shift the AD curve further to the right.

Appropriate when the economy is in equilibrium below full-employment, eg: a recession.



Price level

Real GDP (billions of

dollars)

0 $1200


100

SRAS1

Expansionary fiscal policy

AD1

LRAS1

AD2(without

policy)

AB

SRAS2

Expansionary fiscal policy causes the AD curve to shift further to the right.

1350

LRAS2

102

1400

103 C

AD3(with policy)


Contractionary fiscal policy: Involves decreasing government purchases and/or increasing taxes.

A decrease in government purchases or an increase in taxes will reduce the rate of increase in aggregate demand, to reduce the inflation rate.

Appropriate when the economy is above full-employment equilibrium and the inflation rate is high.



Price level

Real GDP (billions of

dollars)

0 $1200


100

SRAS1

AD1

LRAS1

AD3(with

policy)

A C

SRAS2

1400

LRAS2

103

1450

104 B

AD2(without

policy)

Contractionary fiscal policy

Contractionary fiscal policy causes the AD curve to shift to the right by less than it would have without policy.

Problem Type of Policy

Actions by the

Government

Result

Recession or slow economic growth

Expansionary Increase government spending or cut taxes

Real GDP and the price level rise by more than they would have without policy

Countercyclical fiscal policy


Problem Type of Policy

Actions by the

Government

Result

Recession or slow economic growth

Expansionary Increase government spending or cut taxes

Real GDP and the price level rise by more than they would have without policy

Rising inflation Contractionary Decrease government spending or raise taxes

Real GDP and the price level do not rise by as much as they would have without policy

Countercyclical fiscal policy



The government purchases multiplier.

An increase in government purchases will increase aggregate demand by more than the initial amount of increase in purchases.

Autonomous expenditure: Expenditure that does not depend in the level of GDP.

Induced expenditure: Expenditure that does depend in the level of GDP.


The multiplier effect and government purchases and tax multipliers



Multiplier: The increase in equilibrium real GDP divided by the increase in

autonomous expenditure.

The multiplier effect: The series of induced increases in consumption spending that results from an initial increase in autonomous expenditure.




An initial increase in autonomous government spending, such as building new railway lines, will increase aggregate demand by an amount that is more than the initial amount of new spending.



Price level

Real GDP0


100

AD1

AD3

AD2

The multiplier effect and aggregate demand: Figure 17.6

1. An initial $10 billion increase in government purchases shifts the aggregate demand curve to the right by $10 billion …

2. … and the multiplier effect results in a further shift.





purchases government in change

GDP real mequilibriu in change multiplier purchases Government

The multiplier effect of an increase in government purchases: Figure 17.7



A simple formula for the multiplier.

Marginal propensity to consume (MPC): The amount by which consumption

spending increases when disposable income increases.



eexpenditur autonomous in change

GDP real mequilibriu in change Multiplier

MPC1-

1


Summarising the multiplier effect.

1. The multiplier effect occurs when autonomous expenditure increases or decreases.

2. The larger the MPC, the larger the value of the multiplier.

3. The formula for the multiplier is oversimplified because it ignores the effect that an increasing GDP can have on imports, inflation and interest rates.




The tax multiplier.

Tax cuts also have a multiplier effect.



taxes in change

GDP real mequilibriu in change multiplierTax


Taking into account the effects of aggregate supply.

The upward sloping aggregate supply curve causes the price level to rise as aggregate demand increases.

As a result, the multiplier effect will not be as great as it would be if prices were

constant.



Price level

Real GDP0


100

AD1

AD3AD2

The multiplier effect and aggregate supply: Figure 17.8

1. An initial increase in government purchases combined with the multiplier effect shifts the aggregate demand curve to the right.

2. Because the SRAS curve is upward sloping, real GDP and the price level are both higher in the new equilibrium.

SRASLRAS

A

C

B

103

$1100 $1120 $1225


The multipliers works in both directions.

Both expansionary and contractionary fiscal policy have a multiplier effect.




The multiplier in reverse, the Great Depression of the 1930s.

More than 1000 unemployed men marched from the Esplanade to the Treasury Building in Perth, Western Australia, to see premier James Mitchell. The multiplier effect had contributed to the very high levels of unemployment during the Great Depression.

MAKING THE CONNECTION17.1


Fiscal policy multipliers

Suppose the Australian economy is currently in equilibrium at a position where actual GDP exceeds potential GDP by $100 million. The Federal Treasurer announces a decision to reduce government spending by $50 million and increase taxes by $50 million in order to return the economy to full employment.

Is the Treasurer’s economic policy sound?




STEP 1: Review the material. This problem is about the multiplier impact of government fiscal policy, which is explained in the section in the text book, ‘The multiplier effect and government purchases and tax multipliers’.

STEP 2: Answer the question by showing that the Treasurer has overlooked the multiplier effect in his policy decision, which means the economy is likely to move to a below full employment equilibrium.




STEP 3: Assume the government purchases multiplier is 2, and the tax multiplier is -1.6.

STEP 4: Use this assumption to calculate the impact of a $50 million decrease in government expenditure of GDP.




Recall the government purchases multiplier is:


Therefore:

purchases government in change

GDP real mequilibriu in change multiplier purchases Government



STEP 5: Now calculate the impact of the increase in taxes.

Recall the tax multiplier is:


taxes in change

GDP real mequilibriu in change multiplierTax



Therefore




STEP 6: The total decrease in GDP is $100 million from the government expenditure effect plus $83 million from the tax effect. GDP decreases by a total of $183 million, much more than is necessary to return the economy to full employment equilibrium.



There are two main problems associated with fiscal policy effectiveness:

Timing lags

Crowding out


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.




Crowding Out: A decline in private expenditures as a result of an increase in government purchases.

An increase in government purchases diverts money and resources away from the

private sector.

Most economists agree that there is partial crowding out in the short run, and complete crowding out in the long run.




Crowding out.

Financial crowding out: To finance a budget deficit, the government will sell more bonds and securities, which will increase the real rate of interest.

Higher interest rates will reduce private investment spending and consumption spending.

Higher interest rates may also cause net exports to decline.




Crowding out.

Resource crowding out: The government competes with the private sector for labour and other resources, putting upward

pressure on prices.

Occurs when the economy is close to full capacity.




Crowding out in the long run.

Most economists agree that there is no long run effect on GDP from a permanent

increase in government spending.

The increase in government purchases is offset by a decrease in private investment, consumption spending and net exports.




Limits to fiscal policy: Japan in the late 1990s.

Fiscal policy in Japan has not been effective in expanding real GDP and reducing unemployment.

MAKING THE CONNECTION17.2


Budget deficit: The situation in which the government’s spending is greater than its tax revenue.

Budget surplus: The situation in which the government’s expenditures are less

than its tax revenue.


Deficits, surpluses and federal government debt

Commonwealth government budget – surpluses and deficits, Australia, 1974/75 to 2009/10: Figure 17.9

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. Australian Government (2009), Budget 2009-10, Budget Overview, Appendix I, Historical budget and net financial worth data, viewed 26 May 2009, at <www.budget.gov.au>

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If the government has a budget deficit, this has to be financed by borrowing, which

contributes to net debt.



Commonwealth government net debt, Australia, 1974/75 to 2009/10: Figure 17.10

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. Australian Government (2009), Budget 2009-10, Statement 7: Asset and Liability Management, Table 2, viewed 26 May 2009, at <www.budget.gov.au>

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How the federal budget can serve as an automatic stabiliser.

Federal government deficits increase automatically during recessions because:

1. Tax revenues fall.

2. Unemployment benefit payments increase.




How the federal budget can serve as an automatic stabiliser.

Federal government deficits decrease or surpluses increase automatically during expansions because:

1. Tax revenues increase.

2. Unemployment benefit payments decrease.




The cyclically adjusted budget deficit or surplus: The deficit or surplus in the federal government’s budget if the economy were at potential GDP.

May provide a more accurate measure of the impact on the economy of government expenditure and taxation policies.



How the level of GDP affects the cyclically adjusted budget deficit: Figure 17.11



Should the federal budget always be balanced?

When the economy is in a recession, tax revenues fall and government spending rises, moving the budget into a deficit.

When GDP is above its potential level during a boom, the budget automatically moves into a surplus – tax revenues rise.

To maintain a balanced budget every year could involve destabilising policies.




Is government debt a problem?

At times, government debt may be necessary, eg: during a recession.

Economists examine the debt level, and the interest repayments on the debt relative to GDP, to determine if it is a problem.

Debt servicing (interest repayments) involves an opportunity cost.

Government borrowing also leads to crowding out.




Debts and deficits

During the 1990s the Australian Federal government operated successive government deficits of over $10 billion dollars. Clearly the government of the day was engaging in vigorous expansionary policy.

Do you agree with this statement?



Debts and deficits

STEP 1: Review the material. This problem is about government deficits, so you may like to read the section in the text book, ‘Deficits, surpluses and federal government debt’.

STEP 2: Answering the question.

The Australian economy experienced a major recession in 1990, due to high interest rates. As a result businesses were less profitable than had previously been the case, and many more people were unemployed.

As a consequence, tax revenues decreased and transfer payments in the form of unemployment and other benefits increased. These factors contributed to the successive budget deficits which followed.



Supply side policies: Fiscal policies that have long-run effects by expanding the productive capacity of the economy and increasing the rate of economic growth.

These policy actions primarily affect aggregate supply rather than aggregate demand, shifting the long-run aggregate supply curve to the right.


The effects of fiscal policy in the long-run


The long-run effects of tax policy. Tax Wedge: The difference between the

pre-tax and post-tax return to economic activity.

Lowering taxes can increase the incentive to work, and encourage investment.

Reducing each of the following taxes can increase aggregate supply.

1. Personal income tax

2. Company income tax

3. Taxes on capital gains




Tax simplification.

There are also potential gains to be derived from simplifying the tax law.

Resources diverted to tax compliance and tax minimisation can be put to more productive uses.

Tax simplification may improve the efficiency of firm and household decision making.




The economic effect of tax reform.

Tax reform can increase the labour force, capital stock and technological change by more than would have occurred without tax reform.

The LRAS curve will shift to the right by more than it otherwise would have.



Price level

Real GDP0

Y1


LRAS1

The supply-side effects of a tax change: Figure 17.12

Y2 Y3

P1

LRAS2 LRAS3

P2

P3

Increase in LRAS without tax changes

Additional increase in

LRAS because of tax changes

AD1

A

B

C


An Inside LookFigure 1 Supply-side policies can increase long-run aggregate

supply, thereby reducing the upward pressure on prices following an increase in aggregate demand

Insert Figure 1 from page 567: As large as possible while

maintaining clarity.


Key Terms Automatic stabilisers

Autonomous expenditure

Budget deficit

Budget surplus

Contractionary fiscal policy

Crowding out

Cyclically adjusted budget deficit or surplus

Discretionary fiscal policy

Expansionary fiscal policy

Fiscal policy

Induced expenditure

Marginal propensity to consumer (MPC)

Multiplier

Multiplier effect

Supply side policies

Tax wedge


The opening case study for Chapter 17 describes the Baby Bonus introduced in 2004 at $4000 and increased over the following years to $5000.

Is the Baby Bonus fiscal policy?

Given the evidence cited in the text book that the Australian economy was at or near full employment in the mid 2000s, why do you think this policy was introduced?

What effect do you think it may have had on the price level?

Get Thinking!


Q1. When the economy is in a recession the government can:

a. Reduce expenditures and leave taxes constant in order to stimulate aggregate demand.

b. Increase government purchases or decrease taxes in order to increase aggregate demand.

c. Decrease government purchases or increase taxes in order to decrease aggregate supply.

d. Change spending and taxation but not aggregate demand or aggregate supply.

Check Your Knowledge


Q1. When the economy is in a recession the government can:

a. Reduce expenditures and leave taxes constant in order to stimulate aggregate demand.

b. Increase government purchases or decrease taxes in order to increase aggregate demand.

c. Decrease government purchases or increase taxes in order to decrease aggregate supply.

d. Change spending and taxation but not aggregate demand or aggregate supply.



Q2. By how much will equilibrium real GDP increase as a result of a $100 billion increase in government purchases?

a. By more than $100 billion.

b. By less than $100 billion.

c. By exactly $100 billion.

d. None of the above. Equilibrium real GDP will not change as a result of an increase in government purchases.



Q2. By how much will equilibrium real GDP increase as a result of a $100 billion increase in government purchases?

a. By more than $100 billion.

b. By less than $100 billion.

c. By exactly $100 billion.

d. None of the above. Equilibrium real GDP will not change as a result of an increase in government purchases.



Q3. Which of these policies can result in ‘crowding out’?

a. Fiscal policy.

b. Monetary policy.

c. Environmental policy.

d. None of the above.



Q3. Which of these policies can result in ‘crowding out’?

a. Fiscal policy.

b. Monetary policy.

c. Environmental policy.

d. None of the above.


Documents

PowerPoint to accompany Chapter 17 Fiscal Policy