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ECONS100 S2 2014
Lecture 9
Chapter 17
Policy
Fiscal
1
L9 Six Learning Objectives
1. Define fiscal policy.
2. Be familiar with some of the recent Australian Federal
Budget decisions and outcomes, and the countercyclical
role of fiscal policy.
3. Explain how the multiplier process works with respect to
fiscal policy.
4. Explain how fiscal policy affects aggregate demand in
the AD/AS model, and how the government can use fiscal
policy to (automatically) stabilise the economy.
5. Discuss the limits (e.g. time lags, crowding out) and
strengths (e.g. crowding in) of fiscal policy.
6. Is government debt a serious problem?
Do stimulus policies bring booms for retailers?
The federal government gave cash payments in 2009 to most people to stimulate consumer spending during a time of economic downturn. Did they work?
The Baby Bonus, which began in 2004 and scrapped in 2013, is another policy which impacts retail spending.
1. Fiscal Policy -What is it? Fiscal policy is using changes in Federal
government spending (G) or taxes (T) to influence
employment and economic growth.
During times of recession, the government
could increase AD by increasing G and/or
reducing T.
During boom times with high inflation, the
government can reduce growth rate of AD by
increasing T and/or reducing G.
Discretionary fiscal policy: when the government
deliberately takes actions to change spending or
taxes to achieve its objectives.
Automatic stabilisers: Government spending and
taxes that automatically increase or decrease
along with the business cycle. (more later, see slides 26-28)
Two types of Fiscal policy
2. Govts Fiscal StrategyDuring an economic slowdown, the government usually supports the economy by:
1) Allowing tax revenue to fall while expenditures rise, which are associated with slower economic growth. This causes a budget deficit;
2) As the economy recovers, the deficit tends to fall as tax revenues rise while expenditures fall. The budget could return to surplus.
The (Australian) Federal Budget
The federal budget in May each year
(e.g. May 13 2014) is the principal fiscal
policy statement for each year.
The budget outcome is usually described
as being in surplus (G < T),
in deficit (G > T), or
balanced (G = T)
The Budget Outcome
The budget outcome is of interest because:
federal government expenditures (i.e.
spending) account for around 20-25% of
GDP.
the budget announces the governments
fiscal stance
Whether the government is trying to expand or
contract economic activity.
2014-15 Aust. Federal Budget Aggregates
(% of GDP)
2011-
12
2012-
13
2013-
14
2014-
15
Revenue
(receipts)22.2 23.1 23.0 23.6
Expenses
(payments)25.0 24.1 25.9 25.3
Underlying
Cash
Balance
-2.9 -1.2 -3.1 -1.8
http://www.budget.gov.au/2014-15/content/overview/download/Budget_Overview.pdf
Budget 2014-15: Revenue
Budget 2014-15: Spending
Australian Govt. Budget (% of GDP) over the Cycle
Global recession
Recovery
A primary objective of fiscal policy Smooth the business cycle
Counter cycle
Government allows budget surpluses during the upswing
Government operates budget deficits during recessionary periods (possibly in recovery phases too).
Impact on economic cycles: macroeconomic stability
encourages private investment in a low interest rate environment
accumulates public debt at a low rate
Countercyclical role of fiscal policy
Countercyclical role of fiscal policy
Government could use fiscal policy as counter cyclical Government has deficits in times when economic
activity is low (recession, recovery)
and surpluses in times when economic activity is high (boom, strong upswing).
Generally, government should use fiscal policy to build up funds during boom times and spend them during crisis and recession. Government pays down debt during good times
Government can borrow to operate deficits during a recession
Problem Type of Policy Actions by the
Government
Result
Recession or
slow economic
growth
Expansionary Increase
government
spending (or reduce 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
Fiscal Policy has a multiplier effect the amount by which GDP is magnified as
a result of a change in government
spending (or taxes)
The government spending multiplier: An increase in government spending will
increase aggregate demand by more
than the initial amount of increase in
spending
3. The Multiplier Effect
The Multiplier Effect
An initial increase in
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.
Process of the Multiplier Effect
i. Investment creates income for workers building the
investment;
ii. They spend some of this income and save some. The
proportion (or fraction) spent is called the Marginal
Propensity to Consume (MPC);
iii. The money spent becomes income for others;
iv. They spend some and save some;
v. Each extra income and spending cycle is smaller than
the previous one.
Multiplier Value = 1 / (1 MPC)
A simple formula for the multiplier.
The value of the multiplier is determined by
the marginal propensity to consume
TheMPC is the amount by which
consumption spending increases when
disposable income increases.
The greater the MPC, the greater the
multiplier.
Multiplier Spending 1
1-MPC
The Multiplier Effect
The Multiplier Effect
New Slide
Multiplier effect occurs from investment, government spending, changing taxes, or changing exports
Example A Intel builds a new factory next to Curtin University
Construction workers earn salaries
New factory hires new workers
These workers spend a portion of their income, MPC, and save the rest They buy new houses, cars, clothes, and appliances
They eat at restaurants and drink coffee at the coffee shops
Multiplier kicks in These businesses experience greater sales and earn more profits
These businesses hire more workers who earn income
These workers buy new houses, cars, clothes, etc.
Multiplier continues as an infinite process
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The Multiplier Effect
The initial increase in G = $10bn
GDP increases by $20bn
The multiplier has a value of 2
The Multiplier Effect
New Slide
Examples Government spending - government builds a new airport
Government taxes government reduces taxes Consumers boost their spending
Exports - China buys more minerals from Australia
Investment businesses invest in new structures, machines, and equipment
Note the AD curve shifts Includes changes of G, I, X, and T
Includes the multiplier effect Effect on the economy.
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Price level
Real GDP (billions of dollars)0
100
AD1
AD3AD2
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.
The Multiplier Effect & AD
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Expansionary fiscal policy
Increasing government expenditure(or decreasing taxes, or both)
The goal is to shift aggregate demand
to the right.
Appropriate when the economy is
below full-employment or in a
recession.
4. Using fiscal policy to influence AD
Expansionary Fiscal Policy
A
AD0
SRAS0
C
0
85
100
115
105
800 1000
Price level
Real GDP
AD0
+ DE
Potential GDP
Increase in government expenditure or tax cut
Multipliereffect
125
B
AD1
1100
Contractionary fiscal policy
Decreasing government expenditure (or increasing taxes, or both)
The goal is to shift aggregate demand
to the left.
Appropriate when the economy is at
an above full-employment equilibrium
and experiences high inflation.
Using fiscal policy to influence AD
AD0 E
A
AD0
SRAS0
C
0
85
95
115
105
12001000
Price
level
Real GDP
Potential GDP
Decreases in government expendituresor tax increase
Multipliereffect
125
B
AD1
Contractionary Fiscal Policy
110
900
Automatic Stabilisers
Government revenues and
expenditures automatically change
over the course of the business cycle.
These changes help to stabilise the
economy, without the need for
government policy decisions.
The importance of automatic stabilisers
Economic expansion automatically reduces a budget deficit or increases a budget surplus, and acts to reduce the rate of expansion of economic activity.
Tax revenue increases and transfer payments (unemployment benefits) fall
Transfer payment government transfers income from one group to another
Helps restrain spending & reduce inflation (peak of cycle not so high)
Contraction automatically increases the
budget deficit or reduces a budget
surplus, which stimulates economic
activity.
Tax revenue decreases & transfer
payments (unemployment benefits) rise
Helps increase spending & offset recession
(trough of cycle not so deep)
The importance of automatic stabilisers
The importance of automatic
stabilisers New Slide - Examples
Boom cycle has low unemployment Workers collect less unemployment benefits
Easier to find work
Gov. spending automatically falls
Families collect less welfare or assistance from gov. Gov. spending automatically falls
Businesses and workers experience growing incomes They pay higher taxes
Recession has high unemployment Workers collect more unemployment benefits
Difficult to find work
Gov. spending automatically rises
Families collect more welfare or assistance from gov.
Businesses and workers experience falling incomes They pay less taxes
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The two potential problems associated with
fiscal policy implementation are:
Time lags
Crowding out (depends )
5. Limits (and strengths) of Using Fiscal Policy to Stabilise the Economy
Recognition lag: the time it takes policy makers
to ascertain there is a problem to be addressed.
Legislative lag: the time it takes for both Houses
of Federal Parliament to pass a policy.
Implementation lag: the time it takes for
government to implement the policy.
Effect or impact lag: the time for the policy to
affect the economy. (could be very short)
Time Lags of Fiscal Policy
Monetary Policy & Fiscal Policy compared
Central bank can implement monetary policy quicker than fiscal policy and is independent of government policy.
Monetary policy is more effective with flexible exchange rates than fiscal policy.
Policy Time Lags
Type of Lag Fiscal
Policy
Monetary
Policy
Decision Slow Quick
Implementation Slow Quick
Effect (Impact) Quick Slow
Productive G enhances private business I
Government spending crowds-out private business investment, such as expenditures on the military, welfare and subsidies. Crowd out as gov. spending rises, businesses reduce their investment
Government spending enhances (crowds-in) private business investment and includes government spending on infrastructure, education, health, transportation and communications. Crowd in - as gov. spending rises, the spending encourages new
investment
Gov. builds a new research institute that leads to new inventions or opens a new site to attract tourists
The policy recommendations are that the neoliberal (and welfare state) tendency to cut productive government spending needs to be reversed. (OHara 2013, p.36)
Source: OHara (2013) Policies and Institutions for Moderating Deep Recessions, Debt Crises and Financial Instabilities, PANOECONOMICUS, 2013, 1, pp. 19-49
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Productive spending from an activist state
Research supports crowd-in when government builds public capital, such as infrastructure, education, telecommunication, and utilities.
In a study of Greece, Ireland, Spain, and Portugal, Laopodis(2001) suggests that non-military public spending on education, infrastructure, and health has a net crowding in (enhancing) effect on private investment and GDP, and that public capital is currently being under-provided.
In a study of Malaysia, Ibrahim (2001) concluded state spending on transport, telecommunications, education, and health had a net crowding in (enhancing) effect on private investment.
Source: OHara (2013) Policies and Institutions for Moderating Deep Recessions, Debt Crises and Financial Instabilities, PANOECONOMICUS, 2013, 1, pp. 19-49.
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Fiscal policies can have long-run effects by
expanding the productive capacity of the economy
and increasing the rate of economic growth.
These policy actions affect AS (but also AD).
e.g. LRAS curve shifts to the right:
Govt. spends on infrastructure such as power
supplies, water, roads etc.
Govt simplifies tax and tax codes that improve the
efficiency of firm and household decision-making.
The Effects of Fiscal Policy in the Long-Run
Should the federal budget always be balanced? NO
When the economy is in a recession, tax revenues fall and
government spending rises. The government operates a deficit.
If government raises taxes or reduces government spending, it
could make the recession worse
When GDP is above its potential level during a boom, the budget
automatically moves into a surplus as tax revenues rise.
If government lowers taxes or increases government spending,
it makes the economy grow faster creating more inflation
To maintain a balanced budget every year could involve destabilising
policies.
Government should only consider a balanced or surplus budget
if the economy experiences serious inflation or an extended,
long expansion cycle.
6. Government Debt
Government Debt: Australia & other advanced economies
Source: http://budget.gov.au/2013-14/content/bp1/html/bp1_bst4-06.htm
Is government debt a problem?
At times, government debt may be necessary, e.g.: in
periods of low growth or during a recession.
As government debt rises, the government pays more
interest on the debt
Government may reduce budgets in other areas to pay
the interest
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) can involve an opportunity cost [when
Government spending is not financed through fiat money].
This is potentially a problem for peripheral nations (e.g. Greece, Spain) in
the Eurozone.
Government Debt
1. When the economy is in a recession the government can:
A. Change spending and taxation but not aggregate
demand or aggregate supply.
B. Reduce expenditures and leave taxes constant in
order to stimulate aggregate demand.
C. Decrease government purchases or increase taxes
in order to decrease aggregate supply.
D. Increase government purchases or decrease taxes
in order to increase aggregate demand.
Review
2. A possible cause of the governments actual
budget surplus to be smaller than its intended
budget surplus could be
A. policy initiatives in the budget to increase spending.
B. a significant appreciation of the Australian dollar.
C. a lower level of economic activity than forecast.
D. a lower level of tax avoidance and evasion than
expected.
Review
3. 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.
Review
4. If the marginal propensity to consume is equal to 0.8 and G is increased by $10bn, then the government spending multiplier is ____ and real GDP will increase by ____.
A. 0.8; $8bn
B. 4; $40bn
C. 5; $50bn
D. 1; $10bn
Review
5. Suppose that real GDP equals $1100 billion while full employment real GDP equals $1200 billion. To close this gap, if the MPC is 0.75 the government should increase its spending by
A. $25 billion
B. $20 billion
C. $15 billion
D. $10 billion
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Review
6. If an economy is experiencing high levels of
unemployment and low levels of economic
growth, the most successful policy is likely to be
A. contractionary monetary policy.
B. expansionary monetary policy.
C. expansionary fiscal policy.
D. Microeconomic reform.
Review
7. An automatic stabiliser ensures that
A. government spending and taxes remain in balance
throughout the business cycle.
B. taxes fall compared to government spending during
downswings, and taxes rise during upswings.
C. taxes rise compared to government spending during
downswings, and taxes fall during upswings.
D. taxes rise compared to government spending
throughout the business cycle.
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Review
8. Which of the following government policies is
most likely to be effective in the short term in
increasing aggregate spending in Australia
during a recession?
A. an increase in infrastructure spending
B. a $900 bonus payment to households
C. a reduction in the GST rate
D. a reduction in personal income tax rates
Review
9. The implementation of changes in monetary policy is typically
A. faster and more flexible than fiscal policy changes.
B. slower and less flexible than fiscal policy changes.
C. faster but less flexible than fiscal policy changes.
D. slower but more flexible than fiscal policy changes.
Review
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