Transcript Chapter 8 Fiscal Policy and the Public Debt

Chapter 8
Fiscal policy and the
public debt
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics by Jackson and McIver
Slides prepared by Muni Perumal
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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
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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
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Federal government finance
• Federal expenditures
– Large expenditure on social security and welfare
– Specific purpose grants
• Federal revenues
– Personal income tax
 The centrepiece of the national tax system
 A progressive tax structure with the average and
marginal tax rates increasing with income
– Company income tax
– Indirect and other taxes
 Goods and services tax (GST) introduced in July 2000
 Excise taxes
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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
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Expansionary fiscal policy
• If budget is initially balanced, moves it towards
a budget deficit during recession
• Increased government spending and/or
lower taxes
• Aim to stimulate economic activity and to move
the economy out of a recession
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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
• Aim to control demand and reduce
demand-pull inflation
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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
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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
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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)
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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
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T
{
Government expenditure
and tax revenue
Built-in stabilisers
Deficit
{
GDP3
GDP1
Surplus
G
GDP2
Real GDP (billions)
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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
• Cure — discretionary fiscal policy
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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
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Cyclically adjusted budget
• Indicates what the budget deficit (or surplus)
would be if the economy were to operate
at potential output throughout the year
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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
 The view that fiscal policy is manipulated by
politicians to maximise voter support may cause
economic fluctuations
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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, thereby
weakening
or cancelling the stimulatory effects of fiscal policy
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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
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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)
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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
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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
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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
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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
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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
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No crowding-out effect
AS
ASLS
Price level
AD1
P3
P2
P1
AD2
Q1
Q2
AD3
Qp
Real gross domestic product
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Crowding-out effect
AS
Price level
ASLS
AD1
P3
P2
P1
AD2
Q1
AD3
Q2 Qp
Real gross domestic product
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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
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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
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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
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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
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Supply-side effect of fiscal policy
ASLS
Price level
AD1
P3
AS1
AS2
P2
=
P1
AD2
Q1 Q2 Q3
Qp
Real gross domestic product
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8-31