2. KEY CONCEPTS TO BE LEARNT IN THIS TOPIC
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Discretionary fiscal policy
The balanced budget multiplier
Automatic stabilisers
Supply-side fiscal policy
The federal budget
The macroeconomic significance of the budget
Implications of the budget outcome for
government debt levels
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3. Fiscal Policy
– Fiscal Policy: Changes in federal government
spending and taxes and that are intended to
achieve macroeconomic policy objectives,
such as full employment, price stability, and
sustainable rates of economic growth.
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4. Fiscal Policy
• Discretionary fiscal policy versus Automatic
stabilisers.
Discretionary fiscal policy is used as a counter
cyclical tool. It is the deliberate changes in
government spending and/or taxation decisions
with the aim of achieving the government’s macro
policy objectives such as low inflation and full
employment.
Automatic stabilisers: Government spending and
taxes that automatically increase or decrease along
with the business cycle.
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5. DISCRETIONARY FISCAL POLICY
• Discretionary fiscal policy is the use of
changes in government spending and/or
taxes to alter aggregate demand (AD) and
stabilise the economy.
• The government can increase AD through
expansionary fiscal policy.
• The government can reduce AD through
contractionary fiscal policy.
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7. INCREASING GOVERNMENT SPENDING TO COMBAT
RECESSION
• In a period of slow economic growth, policy makers
could either:
– do nothing and wait for the business cycle to
expand, or
– increase government spending.
• This expansionary fiscal policy would:
– shift the AD curve outwards (to the right)
– increase real GDP
– raise the price level.
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9. THE AMOUNT OF SPENDING
REQUIRED
• Initial spending by the government is amplified, as a
spending multiplier occurs.
– Those receiving the money spend some of it on
goods and services, which creates a ripple effect.
• The proportion spent depends on the marginal
propensity to consume (MPC).
• We use this to calculate the spending multiplier.
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10. Marginal Propensity to Consume (MPC)
• Disposable Income (YD) = the income of
households plus transfers received from the
government less taxes paid to the government.
• Since YD can only be consumed (C) or saved (S):
YD = C + S
where C = consumption
expenditure
S = Saving
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11. Marginal Propensity to Consume (MPC)
(continued..)
• Marginal Propensity to consume (MPC) = change in
consumption expenditure (ΔC) divided by change in
disposable income (ΔYD):
MPC = ΔC / ΔYD
• Example:
Period 1
Period 2
Change
Yd
$30,000
$40,000
$10,000
C
$25,000
$32,500
$7,500
Then MPC = $7,500 / $10,000
MPC = 0.75
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12. The Spending Multiplier
Change in
Income
MPC
Change in Y
Period 2
$10,000
0.75
$7,500
Period 3
$7,500
0.75
$5,625
Period 4
$5,625
0.75
$4,218.75
Period 5
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13. THE SPENDING MULTIPLIER
Assume the MPC is 0.75
Each dollar of expansionary government spending creates
75 cents in extra purchasing power.
In the next round of spending, the $0.75 creates an
additional $0.56 in spending power; then $0.42 in the next.
An extra $1 creates $4 in extra spending.
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14. THE SPENDING MULTIPLIER
• We can use a formula to determine the
spending multiplier:
1
1 – MPC
The multiplier =
The multiplier =
The multiplier =
1
1 – 0.75
1
0.25
The multiplier = 4
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15. THE SPENDING MULTIPLIER
• If MPC is 0.75, using the formula
(1 / 1- MPC), the spending multiplier is 4.
• An initial increase in $1 billion government
spending will result in $4 billion extra spending.
• If MPC is 0.8, using the formula,
(1 / 1- MPC), the spending multiplier is 5.
• If MPC is 0.85, using the formula,
(1 / 1- MPC), the spending multiplier is 6.7.
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16. CUTTING TAXES TO
COMBAT A RECESSION
• Cutting taxes would also expand the economy and
help restore full employment.
• This policy would also:
– shift the AD curve outwards
– increase real GDP
– raise the price level.
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17. THE EFFECT OF A TAX CUT
A tax cut worth $10 billion creates $10 billion extra
disposable income.
When MPC is 0.75, this creates an extra $7.5 billion in
spending.
This is less than the initial effect of a spending increase,
as a fraction of the tax cut is saved rather than spent.
Thus the tax cut results in a smaller expansionary effect.
Maybe Not! There is some debate over the size of multipliers.
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19. USING FISCAL POLICY
TO COMBAT INFLATION
• Contractionary fiscal policy can also be effective
against demand-pull inflation.
• Cutting spending reduces aggregate demand (a
‘negative’ spending multiplier applies in this case).
• The price level will decrease.
• The government could also raise taxes.
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21. THE BALANCED BUDGET MULTIPLIER
• This refers to an equal change in government
spending and taxes.
• This gives a neutral effect (zero-sum) on
government finances – a prudent way of
financing government.
• The balanced budget multiplier is equal to 1,
and the cumulative change in aggregate
demand is always equal to the amount of the
initial change in government spending.
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22. THE BALANCED BUDGET MULTIPLIER (continued)
• Example: Assume a $1 billion increase in government spending and
a $1 billon increase in taxes to finance that spending.
• with MPC = 0.75, the spending multiplier is 4. Then, the increase in
government spending being $1 billion, the addition to aggregate
demand is 4 billion (= $1 billion x 4).
• With increase in taxes of $1 billion, the MPC = 0.75, the direct
reduction in consumption is only $ 0.75 billion ($1 billion x 075).
The spending multiplier in this case = 4. Thus, the reduction in
aggregate demand is $3 billion ($0.75 billion x 4).
Therefore, cumulative increase in aggregate demand is $1 billion
($4 billion - $ 3 billion), which is exactly equal to initial government
spending of $1 billion.
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23. Baby bonus brings a boom for retail spending
The Baby Bonus
illustrates the
impact
government
expenditure
programs can
have on economic
activity
throughout the
Economy.
24. Further Reading on the Baby Bonus
The the Baby Bonus was introduced in 2004 at
$4,000 and increased over the following years
to $5,000. The Australian economy was at or
near full employment in the mid 2000s. There
was a claim that the Baby Bonus precipitated
an increase in retail spending. (Follow the link
below to find out more about the Baby Bonus).
http://www.babybonus.com.au
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25. AUTOMATIC STABILISERS
• Government revenues and expenditures
automatically change over the course of the
business cycle.
• These changes help to stabilise the economy
to some extent, without the need for
changing government spending too much.
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26. AUTOMATIC STABILISERS (CONT.)
• Transfer payments (e.g. job search allowance)
fall as GDP rises, mainly because
unemployment falls.
• On the other hand, tax revenues and GDP are
directly related (higher personal and business
incomes).
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28. SUPPLY-SIDE FISCAL POLICY
• This reflects government policies that increase
aggregate supply to achieve long-run growth in
real output, full employment and a lower inflation
level.
• Examples:
– microeconomic reform in Australia, e.g. tax
reform, deregulation, Work Choices
– the Reagan tax cuts in the USA.
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30. The Limits of using Fiscal Policy to
Stabilise the economy
• Timing lags
– Recognition lag: the time it takes policy makers to
ascertain there is a problem to be addressed.
– Legislative lag: the time it takes to have policy
approved by both Houses of Federal Parliament.
– Implementation lag: the time it takes to
implement the policy, and for the policy
to take effect.
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31. Limits to Fiscal Policy: The Crowding Out Issue
• Crowding out occurs when there is a reduction in private sector
spending due to federal budget deficits being financed by
government borrowing.
• In order to finance the deficit, the government must compete
for funds in the finance market which increases interest rates.
• High rates dissuade private sector spending (or borrowing to
invest).
• Crowding out will reduce the impact of expansionary fiscal
policy.
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32. THE FEDERAL BUDGET
• The Australian federal budget (May each year) is
the principal fiscal policy statement each year.
• The budget outcome is usually described as
being:
– in surplus (government revenue exceeds government
spending); or
– in deficit (government spending exceeds government
revenue).
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33. THE BUDGET OUTCOME
• The budget outcome is of interest because:
– federal government outlays are a considerable
percentage of GDP
– the budget announces the government’s fiscal
stance (whether the government is trying to
expand or contract economic activity).
– The Australian Government Budget
– The New Zealand Goverment Budget
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37. Government expenditure by function, 2007/08
Source: Australian Government (2007), Budget 2007-08, Appendix D, Australian
government taxation and spending, viewed 5 May 2008, at www.budget.gov.au.
Copyright Commonwealth Government of Australia. Reproduced by permission.
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38. Government revenue by source, 2007/08
Source: Australian Government (2007), Budget 2007-08, Appendix D, Australian
government taxation and spending, viewed 5 May 2008, at www.budget.gov.au.
Copyright Commonwealth Government of Australia. Reproduced by permission.
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39. THE COUNTERCYCLICAL
ROLE OF FISCAL POLICY AND THE BUDGET
• The countercyclical role of fiscal policy implies budget
deficits in times when economic activity is low
(recession) and budget surpluses in times when
economic activity is high (boom).
Many governments now place an emphasis on
their budgets being ‘in balance’ over the course
of the business cycle in order to show that they
are responsible and are safe borrowers.
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42. OTHER ROLES OF FISCAL POLICY
• The budget also reflects medium-to-longterm goals.
• Recent policy initiatives have included:
– the introduction of the GST in 2000, which
broadened the tax base
– greater focus on economic growth
– focus on reducing the unemployment rate.
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43. IMPLICATIONS OF THE BUDGET OUTCOME FOR GOVERNMENT
DEBT
• Budget deficits add to government debt.
– This is the total value of outstanding government
securities.
• The Australian government debt to external parties is
relatively low in comparison to OECD figures.
• Future budget deficits will need to be financed by
money or debt financing.
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45. THE BURDEN OF THE DEBT
• The burden of the debt is the possibility that
government debt could create a burden on future
generations.
• It should be remembered, however, that much
wealth creation involves the use of borrowing and
debt.
• Much government debt has also been used to
finance infrastructure.
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46. THE EXTERNAL COMPONENT OF NATIONAL DEBT
• The portion of a country’s national debt that is owed
to foreigners is a different matter.
• Currently Australia has a negligible component of
national debt.
• This is an external debt that should increase the
quantity of output from future production, but will
also involve repayment with interest to foreigners.
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47.
48.
49. Commonwealth government budget – surpluses and deficits, Australia,
1974/75 to 2007/08
Source: Australian Government (2007), 2007-08 Budget Overview, Appendix G, Historical
budget and net debt data, viewed 5 May 2008, at www.ato.gov.au. Copyright Commonwealth of
Australia. Reproduced by permission
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50. SUMMARY
• Discretionary fiscal policy; changes to government spending
and/or taxes
• Expansionary fiscal policy and Contractionary fiscal policy
• Spending multiplier, tax multiplier and balanced budget
multiplier
• Timing lags and Crowding out issue
• Automatic stabilisers
• Supply side fiscal policy
• Budget deficit, budget surplus and debt
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51. Self-Review Questions
• What is discretionary fiscal policy? What are automatic
stabilisers?
• What type of fiscal policy that the government will
implement in case of a recession? What are the effects of
such a fiscal policy on aggregate demand, real GDP an the
price level?
• What type of fiscal policy that the government will
implement in case of increasing inflation? What are the
effects of such a fiscal policy on aggregate demand, real
GDP an the price level?
• What are the limits to using discretionary fiscal policy?
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