10-1Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Chapter 10

Fiscal policy and the public debt

10-2Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-3Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-4Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Federal Government Finance

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

• Federal revenues– personal income tax– company income tax

Double taxation a highly controversial problem

– Indirect and other taxes sales tax excise tax.

10-5Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-6Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Expansionary Fiscal Policy• The use of increased government spending and/or

lower taxes, thereby increasing the government budget deficit, to stimulate economic activity and the move the economy out of recession or depression.

10-7Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Contractionary Fiscal Policy

• The use of reductions in government spending and/or higher taxes, thereby reducing the deficit or increasing the surplus in the government’s budget, to control demand-pull inflation.

10-8Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Financing Deficits

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

‘crowding out’ some investment spending and some interest-sensitive consumer spending.

– Money creation: Deficit financed by the RBA by issuing new

money Avoids crowding out of private spending.

10-9Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Disposing of Surpluses • Effect of contractionary fiscal policy depends on the

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): when the government withholds purchasing power.

10-10Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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).

10-11Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-12Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Built-in Stabilisers

Go

vern

men

t ex

pen

dit

ure

an

d t

ax r

even

ue

($ b

illio

ns)

Real GDP (billions)

GDP3

T

G

GDP2

{

Surplus

{Deficit

GDP1

10-13Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Fiscal Drag• Occurs when an economy stabilises at an

undesirable output level because of the operation of automatic stabilisers.

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

• The cure is: Discretionary fiscal policy.

10-14Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Cyclically Adjusted Budget• Indicates what the budget deficit (or surplus) would

be if the economy were to operate at potential output throughout the year.

10-15Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Problems with Fiscal Policy in Practice• Problems of timing

– recognition lag– administrative lag– operational lag

• Political problems– other economic goals: not just stability– expansionary bias– a political business cycle.

10-16Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-17Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-18Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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).

10-19Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.– Government can create more money.

• Shifting burdens, future generations will pay for it.

10-20Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Problems with Public DebtEconomic implications:• External debt may be a problem.• Increased taxes may dampen incentives.• Income distribution affected.

– Government bonds are generally held by those wealthier members of society.

• Composition important: capital versus consumer goods.

10-21Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-22Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-23Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-24Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

No Crowding-Out Effect

ASLS

Qp

Pri

ce l

evel

Real gross domestic product

AS

AD2

Q1 Q2

AD1

P1

P3

AD3

P2

10-25Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Crowding-Out Effect

ASLS

Qp

Pri

ce le

vel

Real gross domestic product

AS

AD2

Q1 Q2

AD1

P1

P3

AD3

P2

10-26Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-27Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

– 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

10-28Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

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.

10-29Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Supply-Side Effect of Fiscal Policy

ASLS

Qp

Pri

ce le

vel

Real gross domestic product

AS1

AD2

Q1

AD1

P1

AS2

Q2

P2

P3 =

Q3

10-30Copyright 2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & BajadaBy Muni Perumal

Next Chapter:

Monetary policy and the financial system