1. 10-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Chapter 10 Fiscal policy and the public debt

2. 10-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

3. 10-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

4. 10-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

5. 10-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

6. 10-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

7. 10-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

8. 10-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

9. 10-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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. 10-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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).

11. 10-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

12. 10-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Built-in Stabilisers Government expenditure and tax revenue ($ billions) Real GDP (billions) GDP 3 T G GDP 2 { Surplus { Deficit GDP 1

13. 10-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

14. 10-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

15. 10-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

16. 10-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

17. 10-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

18. 10-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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).

19. 10-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

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

21. 10-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

22. 10-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

23. 10-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

24. 10-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal No Crowding-Out Effect AS LS QpQp Price level Real gross domestic product AS AD 2 Q1Q1 Q2Q2 AD 1 P1P1 P3P3 AD 3 P2P2

25. 10-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Crowding-Out Effect AS LS QpQp Price level Real gross domestic product AS AD 2 Q1Q1 Q2Q2 AD 1 P1P1 P3P3 AD 3 P2P2

26. 10-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

27. 10-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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

28. 10-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By 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.

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

30. 10-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal Next Chapter: Monetary policy and the financial system