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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