ECONS100

S2 2014

Lecture 9

Fiscal
Policy

Chapter 17

L9 Six Learning Objectives

1.
2.

3.
4.

5.
6.

Define fiscal policy.

Be familiar with some of the recent Australian Federal
Budget decisions and outcomes, and the countercyclical
role of fiscal policy.
Explain how the multiplier process works with respect to
fiscal policy.
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.
Discuss the limits (e.g. time lags, crowding out) and
strengths (e.g. crowding in) of fiscal policy.
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.

Two types of Fiscal policy

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)

2. Govts Fiscal Strategy

During 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)
201112
Revenue

201213

201314

201415

22.2

23.1

23.0

23.6

25.0

24.1

25.9

25.3

-2.9

-1.2

-3.1

-1.8

(receipts)
Expenses
(payments)
Underlying
Cash
Balance

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

Recovery

Global recession

Countercyclical role of fiscal policy

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

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

Countercyclical fiscal policy

Problem
Recession or
slow economic
growth

Type of Policy Actions by the

Government
Expansionary

Increase
government
spending
(or reduce taxes)

Rising inflation

Contractionary

Decrease
government
spending
(or raise taxes)

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

3. The Multiplier Effect

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

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

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.
i.

Multiplier Value = 1 / (1 MPC)

The Multiplier Effect

A simple formula for the multiplier.

The value of the multiplier is determined by

the marginal propensity to consume
The MPC is the amount by which
consumption spending increases when
disposable income increases.
The greater the MPC, the greater the
multiplier.
Spending Multiplier

1
1- MPC

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

20

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.
22

The Multiplier Effect & AD

Price level
2. and the
multiplier
effect results
in a further
shift.

100
1. An initial $10
billion increase in
government
purchases shifts
the aggregate
demand curve to
the right by $10
billion

0
23

AD3
AD2
AD1
Real GDP (billions of dollars)

4. Using fiscal policy to influence AD

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.

Expansionary Fiscal Policy

Price level

125

Increase in
government
expenditure
or tax cut

Potential
GDP
Multiplier
effect

SRAS0

115
C
105
B
100
A

AD1

85
AD0
0

800

AD0 + DE

1000 1100
Real GDP

Using fiscal policy to influence AD

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.

Contractionary Fiscal Policy

Price
level

Potential
GDP

Decreases in
government
expenditures
or tax increase

125
115
110
105

SRAS0
Multiplier
effect

95

AD0

85

AD0 E

AD1

900 1000

1200
Real GDP

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)

The importance of automatic stabilisers

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
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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5.

Limits (and strengths) of Using

Fiscal Policy to Stabilise the Economy

The two potential problems associated with
fiscal policy implementation are:
Time lags
Crowding out (depends )

Time Lags of Fiscal Policy

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)

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

36

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.
37

The Effects of Fiscal Policy in the Long-Run

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.

6. Government Debt
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.

Government Debt: Australia & other advanced economies

Source: http://budget.gov.au/2013-14/content/bp1/html/bp1_bst4-06.htm

Government Debt
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.

Review
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.
B.
C.
D.

policy initiatives in the budget to increase spending.

a significant appreciation of the Australian dollar.
a lower level of economic activity than forecast.
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.
B.
C.
D.

By more than $100 billion.

By less than $100 billion.
By exactly $100 billion.
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.
B.
C.
D.

0.8; $8bn
4; $40bn
5; $50bn
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.
B.
C.
D.

$25 billion
$20 billion
$15 billion
$10 billion

46

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.
B.
C.
D.

contractionary monetary policy.

expansionary monetary policy.
expansionary fiscal policy.
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.

48

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.
B.
C.
D.

an increase in infrastructure spending

a $900 bonus payment to households
a reduction in the GST rate
a reduction in personal income tax rates

Review
9. The implementation of changes in monetary
policy is typically
A.
B.
C.
D.

faster and more flexible than fiscal policy changes.

slower and less flexible than fiscal policy changes.
faster but less flexible than fiscal policy changes.
slower but more flexible than fiscal policy changes.

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