Fiscal Policy How the Government affects my money! Because the government is so large and has such an impact on business, the decisions it makes has a HUGE influence on the economy. The Federal Reserve (another government agency) DOES NOT make fiscal policy. We will discuss the Federal Reserve next class.

Federal Government Finance Federal expenditures – large expenditure on social security and welfare – specific purpose grants Federal revenues – Personal income tax – Company income tax – Indirect and other taxes GST excise tax Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-2

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 Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-3

Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a) If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand

Expansionary Fiscal Policy Increased government spending or lower taxes or increased transfer payments (social security payments) to reduce the effects of recession, i.e. boost GDP and reduce unemployment Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-5

Decreasing Taxes 1.Gives people more money to spend 2.More money = more demand 3.More demand = more production 4.More production = more jobs 5.More jobs = more demand etc. etc.

Increase Spending 1.Increases demand for goods 2.More demand = more production 3.More production = more jobs 4.More jobs = more demand etc. etc.

Expansionary Fiscal Policy Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-8 AS L S QpQp Price level Real gross domestic product AS 1 AD 2 Q1Q1 AD 1 P1P1 Q2Q2 P2P2

Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a) In panel (a), the economy is initially at E 1, where real GDP exceeds long-run equilibrium Contractionary fiscal policy can move aggregate demand to AD 2 via a tax increase A new equilibrium is at E 2 at a lower price level Real GDP is now consistent with LRAS

Contractionary Fiscal Policy Decreased government spending or higher taxes or a reduction in transfer payments in order to reduce inflation during a boom Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-10

Increase Taxes 1.People have less money to spend 2.Less money = less demand 3.Less demand = lower inflation

Decrease Spending 1.Less money in economy 2.Less money = less demand 3.Less demand = lower inflation

Contractionary Fiscal Policy Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-13 AS L S QpQp Price level Real gross domestic product AS 1 AD 1 Q1Q1 AD 2 P1P1 P2P2

Contractionary and Expansionary Fiscal Policy: Changes in Taxes, Panel (a) In panel (a), the economy is initially at E 1, where real GDP exceeds long-run equilibrium Contractionary fiscal policy can move aggregate demand to AD 2 via a tax increase A new equilibrium is at E 2 at a lower price level Real GDP is now consistent with LRAS

Non-Discretionary Fiscal Policy Built-in or automatic stabilisers that operate without requiring explicit action by policy-makers, they are the result of a progressive income taxes and a social security system During recessions: Tend to increase government deficits (or reduce surplus) through lower taxes and higher welfare payments During inflationary periods: Tend to increase government surpluses (or reduce deficits) through higher taxes and lower welfare payments Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-15

Automatic or Built-in Stabilisers Tax receipts: Increase as real GDP increases, so the economy slows Transfers: Decrease as real GDP increases, but increase when the economy slows so GDP and AD increase. Do not fully correct the economy, only reduces the severity of fluctuations Useful when economy is operating around full employment Can cause problems: Fiscal Drag Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-16

Automatic or Built-in Stabilisers Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 5-17 Level of business activity Time Flatten out the fluctuations in the business cycle, but do not eliminate them completely

Problems with Fiscal Policy in Practice Problems of timing – Recognition lags – Administrative lags – Operational lags Political problems – Other economic goals, economic growth complements and conflicts with other policies – Expansionary bias, often not used stimulate rather than slow the economy – The political cycle may accentuate the business cycle. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 9-18

Crowding-Out Effect – The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.

The Crowding-Out Effect, Step by Step

The Crowding-Out Effect Expansionary policy causing deficit spending initially shifts from AD 1 to AD 2 Due to crowding out, AD shifts inward to AD 3 Equilibrium GDP below full-employment GDP—recessionary gap

The supply-side effects of changes in taxes – Expansionary fiscal policy could involve reducing marginal tax rates. Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more. The increased productivity will lead to more economic growth.

Supply-Side Economics – The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward

Laffer Curve Tax rates and tax revenues rise together Tax revenues are at a maximum Tax rates and tax revenues fall together