Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra,

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver

Slides prepared by Muni Perumal, University of Canberra, Australia9-1

Chapter 9

Fiscal Policy and the Public Debt



Learning Objectives

• Briefly outline the nature of federal government expenditures and revenues.

• Explain how a degree of economic stability is built into our tax system.

• Survey some basic problems in the application of fiscal policy.



Learning Objectives (cont.)

• Briefly discuss several contrasting budget philosophies.

• Assess the quantitative and qualitative aspects of the public debt.

• Discuss the implications of and complications associated with fiscal policy within the aggregate demand–aggregate supply framework



Federal Government Finance

• Federal expenditures– large expenditure on social security and welfare– specific purpose grants

• Federal revenues– Personal income tax– Company income tax– Indirect and other taxes

sales tax excise tax



Discretionary Fiscal Policy

• The deliberate manipulation of taxes and spending by government for the purpose of altering real GDP and employment, controlling inflation and stimulating economic growth

• Not all fiscal policy is deliberate



Expansionary Fiscal Policy

• If budget is initially balanced, moves it towards a budget deficit during recession

• Increased government spending and/or lower taxes



Contractionary Fiscal Policy

• If budget is initially balanced, moves it towards a budget surplus during an inflationary period

• Decreased government spending and/or higher taxes



Financing Deficits

• Effect of expansionary fiscal policy depends on method by which the deficit is financed– Borrowing: May increase interest rates,

thus ‘crowding out’ some investment– Money creation:

Deficit financed by the RBA by issuing new money

Avoids crowding out private spending



Disposing of Surpluses

• Effect of contractionary fiscal policy depends on method by which the surplus (or movement towards surplus) is financed– Debt reduction: May reduce anti-inflationary

impact of policy by reducing interest rates, thereby stimulating private spending

– Idle surplus (or impounding): Government withholds purchasing power



Non-Discretionary Fiscal Policy

• Built-in stabilisers that operate without requiring explicit action by policy-makers

• During recessions: Tend to increase government deficits (or reduce surplus)

• During inflationary periods: Tend to increase government surpluses (or reduce deficits)



Automatic or Built-in Stabilisers

• Tax receipts: Increase as real GDP increases

• Transfers: Decrease as real GDP increases

• Do not correct; only reduce the severity of fluctuations

• Useful when economy is operating around full employment

• Can cause problems: Fiscal Drag



Built-in Stabilisers

Go

vern

men

t ex

pen

dit

ure

an

d t

ax r

even

ue

Real GDP (billions)

GDP3

T

G

GDP2

{

Surplus

{Deficit

GDP1



Fiscal Drag

• Occurs when an economy stabilises at an undesirable output level because of the operation of automatic stablisers

• Over time as an economy grows, this can choke off growth

• Cure: Discretionary fiscal policy



A Government’s Fiscal Stance

• Difficult to judge. Why?• Actual budget surpluses or deficits in

any given year do not necessarily indicate the government’s true fiscal stance. Why?

• Built-in stability• Solution: Cyclically adjusted budget



Cyclically Adjusted Budget

• Indicates what the budget deficit (or surplus) would be if the economy were to operate at potential output throughout the year



Problems with Fiscal Policy in Practice

• Problems of timing– Recognition lags– Administrative lags– Operational lags

• Political problems– Other economic goals: not just stability– Expansionary bias– A political business cycle



Problems with Fiscal Policy in Practice (cont.)

• Crowding-out effect– When an expansionary fiscal policy

tends to increase the interest rate, thus reducing interest-sensitive private spending, especially investment



Managing Public Debt: Various Philosophies

• Annually balanced budget– Pro-cyclical: intensifies recession or

inflation

• Cyclically balanced budget– Counter-cyclical– Not annually balanced– Problem: upswings and downswings may

not be of equal magnitude



Managing Public Debt: Various Philosophies (cont.)

• Functional finance– Primary purpose is to balance the

economy, not the budget– The problems of continuing annual deficits

(or surpluses) may be small compared to the alternative: recession and high unemployment (inflation)



Public Debt

• The total accumulation of the Federal Government’s total deficits and surpluses over time

Myths about public debt:• Government is going bankrupt

– Government can refinance existing debt– Can create more money

• Shifting burdens, future generations will pay for it



Problems with Public Debt

Economic implications

• External debt may be a problem

• Increased taxes may dampen incentives

• Income distribution– Government bonds are generally held by those

wealthier members of society

• Composition important: capital versus consumer goods



Problems with Public Debt (cont.)

Crowding-out and the stock of capital• Future generations inherit a

smaller stock of capital goods due to the crowding-out effect, which increases interest rates and so reduces investment spending

• Two qualifications– Public investment– Unemployment



Public Debt: Positive Role

• Debt creation transfers saving to spenders and thereby may play a positive function in maintaining a high level of output and employment



Inflation and Fiscal Policy

• Some portion of the potential effect of an expansionary fiscal policy on real output and employment may be dissipated in the form of inflation

• The effect of fiscal policy on inflation affects net exports through the foreign purchases effect



No Crowding-Out EffectASLS

Qp

Pri

ce l

evel

Real gross domestic product

AS

AD2

Q1 Q2

AD1

P1

P3

AD3

P2



Crowding-Out EffectASLS

Qp

Pri

ce le

vel


AS

AD2

Q1 Q2

AD1

P1

P3

AD3

P2



Fiscal Policy and the Open Economy

• The effectiveness of fiscal policy can be altered by international conditions:– Shocks from abroad: small economies are

susceptible to international shocks that can alter our GDP and render our fiscal policies inappropriate

– Net export effect



Net Export Effect

• The impact of interest rate-induced change in the exchange rate, and thus net exports, following changes in fiscal policy– Expansionary fiscal policy results in higher

interest rates resulting in increased demand for $A resulting in appreciation of $A resulting in a decline in net exports



Net Export Effect (cont.)

– Contractionary fiscal policy results in lower interest rates resulting in decreased demand for $A resulting in depreciation of $A resulting in an increase in net exports

• Reduces the overall impact of fiscal policy



Fiscal Policy and Aggregate Supply

• Fiscal policy, especially tax changes, affects not only aggregate demand but can affect aggregate supply

• Tax changes in the form of incentives to businesses and individuals can lead to a rightward shift in the AS, providing a further stimulus to the economy in terms of lower prices and higher GDP



Supply-Side Effect of Fiscal Policy

ASLS

Qp

Pric

e le

vel


AS1

AD2

Q1

AD1

P1

AS2

Q2

P2

P3 =

Q3



Next Chapter:

Money, Banking and the Financial System

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra,

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