Transcript Bajada, Economic Principles 3e

Chapter 10
Fiscal policy and the
public debt
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10- 1
Learning objectives
1. Briefly outline the nature of federal government
expenditures and revenues.
2. Explain how a degree of economic stability is built
into our tax system.
3. Survey some basic problems in the application of
fiscal policy.
4. Briefly discuss several contrasting budget
philosophies.
5. Assess the quantitative and qualitative aspects of
the public debt.
6. Discuss the implications of and complications
associated with fiscal policy within the aggregate
demand–aggregate supply framework.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Federal government finance
• Federal expenditures
–
–
–
–
Final consumption of goods and services
Expenditure on new fixed assets
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
 GST and excise taxes
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Discretionary fiscal policy
• The deliberate manipulation of taxes and
spending by government in order to alter real
GDP and employment, control inflation and
stimulate economic growth.
• Not all fiscal policy is deliberate.
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Expansionary fiscal policy
• The use of increased government spending
and/or lower taxes, thereby increasing the
government budget deficit, to stimulate
economic activity and move the economy out
of recession or depression.
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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
in order to control demand-pull inflation.
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Financing deficits
• The 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
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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.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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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 surpluses).
• During inflationary periods: tend to increase
government surpluses (or reduce deficits).
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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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
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
10- 10
T
{
Government expenditure
and tax revenue ($ billions)
Built-in stabilisers
Deficit
{
GDP3
GDP1
Surplus
G
GDP2
Real GDP (billions)
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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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.
• The cure is: discretionary fiscal policy
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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 lag
– Administrative lag
– Operational lag
• Political problems
– Other economic goals: not just stability
– Expansionary bias
– A political business cycle
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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
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Managing public debt: various
budget 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).
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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The public debt
• The total accumulation of the federal
government’s total deficits minus surpluses
over time
• Financing wars and expansionary policies in
recessions responsible for most of
accumulated debt
• Size of debt to GDP ratio has declined
• Interest burden on debt has not been large
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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The public debt (cont.)
Myths about public debt:
• Government is going bankrupt
– Government can refinance existing debt.
– Government can create more money
• Debt is a burden to all Australians
• Shifting burdens, future generations will pay for it
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Problems with public debt
Economic 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
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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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.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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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.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
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No crowding-out effect
AS
ASLS
Price level
AD1
P3
P2
P1
AD2
Q1
AD3
Q2 Qp
Real gross domestic product
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
10- 24
Crowding-out effect
ASLS
Price level
AD2 AD
AS
3
AD1
P3
P2
P1
Q1
Q2
Qp
Real gross domestic product
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
10- 25
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
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
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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.
– 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
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
10- 27
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.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
10- 28
Price level
Supply-side effect of fiscal policy
AS1
ASLS
AD1
AS2
P2
P3 = P1
AD2
Q1
Q2Q3
Qp
Real gross domestic product
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
10- 29
Next chapter
Monetary policy and
the financial system
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
10- 30