1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-1 Chapter 8 Fiscal policy and the public debt

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-2 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

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-3 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

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-4 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

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-5 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

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-6 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

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-7 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

8. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-8 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

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-9 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

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-10 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)

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-11 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

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-12 Built-in stabilisers Government expenditure and tax revenue Real GDP (billions) GDP 3 G GDP 2 { Surplus GDP 1 { Deficit T

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-13 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

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-14 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

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-15 Cyclically adjusted budget Indicates what the budget deficit (or surplus) would be if the economy were to operate at potential output throughout the year

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-16 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

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-17 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

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-18 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

19. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-19 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)

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-20 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

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-21 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

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-22 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

23. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-23 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

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-24 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

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-25 AD 2 No crowding-out effect AS LS QpQp Price level Real gross domestic product AS Q1Q1 Q2Q2 AD 1 P1P1 P3P3 AD 3 P2P2

26. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-26 Crowding-out effect AS LS QpQp Price level Real gross domestic product AS Q1Q1 AD 1 P1P1 P3P3 P2P2 AD 3 AD 2 Q2Q2

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-27 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

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-28 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

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-29 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

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-30 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

31. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 8-31 Supply-side effect of fiscal policy AS LS QpQp Price level Real gross domestic product AS 1 AD 2 Q1Q1 AD 1 P1P1 AS 2 Q2Q2 P2P2 P 3 = Q3Q3