What is the Role of Fiscal Policy in the Economy

7/28/2019 What is the Role of Fiscal Policy in the Economy

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WHAT IS THE ROLE OFFISCAL POLICY IN THE

ECONOMY?


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What is Fiscal Policy?

Fiscal Policy is the use of changes in the level anddirection ofgovernment spending (G) and revenue (T) toinfluence

income distribution,

resource allocation and the level ofeconomic activity.

The main instrument of Fiscal Policy is the

Commonwealth Government Budget. It is anannouncement of the planned levels ofG and T for thefinancial year.

The Budget Papers set out the government expenditure(G) as Expenses and government receipts (T) as

Revenue.


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What is Fiscal Policy?

There are 3possible budget outcomes.

They are:

a Deficit Budget, G > T

a Surplus Budget, T > G

a Balanced Budget, G = T


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Australian GovernmentBudgets

AustralianGovernments overmuch of the last 30

yearshave runBudget Deficits.

This has often beendone in an attempt toreduce the level of

unemploymentor asa result of the level

of unemployment, inAustralia.

2007-08


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Budget Deficits and PublicDebt

The effect of these

regular budget

deficits was an

increase in thePublic Debt in

money termsand

increased pressure

on the ForeignDebt in the period

up to 1995.


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Commonwealth General Government Net Debt and

Net Interest Outlays to GDP

Since then public debt has

been on decline due to budget

surpluses and in 2006 was

fully paid off.The Global Financial Crisis

that began in 2008 turned the

Australian Budget back into

a deficit due to falling taxrevenue, increased spending

on welfare and a stimulus

package to create growth in

the economy.


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HOW DOES THE BUDGETAFFECT THE ECONOMY?

The Governments Fiscal Stance refers to whether it istrying to increase growth (expansionary policy)orslow the rate of growth in the economy

(contractionary policy).

This is not simply a matter of having a budget deficit orsurplus.When the economy is growing thisautomatically reduces G and increases T (lessspending on welfare and more tax revenue, due tolower unemployment levels).


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The Budget has a number of effects on the economy.

Initially changes inG will affect the level ofaggregate expenditureandaggregate demandandthusincomein the economy.

The income change will be magnified by themultipliereffect.

Any increase in income generatesincreasedemployment and economic growth, while reductionsin income do the opposite.


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What effect will increasedGovernment Expenditure have?

Arise in Gwill shiftthe aggregateexpenditure curve

upwardsby the sizeof the increase,

eg a rise in G of 200will increase

equilibrium incomein the economy from400 to 800.

In this case the

multiplier is 2.

0

200

400

600

800

1000

1200

1400

0 400 800 1200

AE

AE +G

45

EXP

Y


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There are also second round orreactionaryeffectsthat occur.

For example an increase in G without a

corresponding increase in T, ie.G > T, willincrease demand and increase income initially,by the multiplier effect.

However, this increase in income will increase

demand for money. If the government finances the budget deficit

by borrowing, this will also increase thedemand for money.


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An increase in thedemand for moneywillshift the demand curve

to the right and increaseinterest rates.

The rise in interest rates

will discourageinvestment r > MEC.This willreduce Ileading to a fall in

Aggregate

0

5

10

15

20

25

30

0 5 10 15 20

r

Quantity of money

s

d1

d2


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So the overall effect of alarger budget deficit due toincreased G will be aninitial large increasein

Aggregate Expenditure,AE1,

followed by a smalldeclinein Aggregate

Expenditure from AE1 toAE2.

Income initially rises to anequilibrium at 800. It then

moves back to 700 as aresult of the rise in

0

200

400

600

800

1000

1200

1400

0 400 800 1200

Exp

Y

AE

AE1AE2

45


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Similarly a cut in thesize of the budgetdeficitor an increase

in the budget surpluswill shift the aggregateexpenditure line downfrom AE to AE1.

This will reducenational incomeandlead to increased

levels ofunem lo ment.

0

200

400

600

800

1000

1200

1400

0 400 800 1200

Exp

Y

AE

AE1

HOW DOES THE BUDGET


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The fall in income and thereduced need for thegovernment to sell bondstofinance the budget deficit

will reduce interest rateswhich will encourage I.

This will lead to a secondaryincrease in aggregate

expenditure, from AE1 toAE2, which willincreaseincome and employment.

The overall effectwill be adecline in income from 800

to 500.

0

200

400

600

800

1000

1200

1400

0 400 800 1200

Exp

Y

AE

AE1

AE2


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How do changes in taxation affectthe level of income?

A decreasein themarginal rate of tax(MRT) will increase theangle of the aggregate

expenditure linefromAE0 to AE1.

This will increase theequilibrium incomelevel

from $500 billion to $800billion.

Similarly an increase inthe MRTwill decrease

the angle of thea re ate ex enditure

0

200

400

600

800

1000

1200

1400

0 400 800 1200

E

x

p

Y

AE0

AE1


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FINANCING THE BUDGETDEFICIT

A budget deficit occurs when G > T.There is ashortage of funds to pay for the governmentspending. The budget has to be financed.There are threepossible ways this can be done.They are:-

Monetary Financing:- This involves theTreasury borrowing from the Reserve Bank. TheReserve Bank prints more money. This isinflationary.


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FINANCING THE BUDGETDEFICIT

Borrowing from the Australian Public:- Thisinvolves the Treasury selling treasury notesand government bondsto Australian citizensand institutions. This increases the demand formoney and pushes up interest rates.

Borrowing from Overseas:- This will increasethe Foreign Debt.


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WHAT IS THE GOVERNMENT

CURRENTLY DOING?

The Australian Government has aimed to achieve a positive

Fiscal Balance.

In the period 1994 to 2008 they reduced the budget deficit

steadily and moved into a surplus.

Most of the achievement of positive fiscal balances

(surpluses) have come about through

Economic growth in the economy reducing unemployment and as

a result reducing welfare spending and increasing tax revenue, cuts to government spending,

increased fees and charges and

allowing wage rises to increase income tax revenue(Fiscal Drag)


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What is the Governments Fiscal

Strategy?

When asset salesare included, eg Telstra, CommonwealthBank, Sydney Airport, there has been a headline cashsurplus in most years since the second half of the 1990s.

The Governments basic plan is to cut governmentspending and to achievebalanced or surplus budgetsoverthelife of the business cycle .

This will increase the Government Finance Statistics NetLending and thus reduce the need to borrow funds fromoverseas.


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WHAT IS THE GOVERNMENTTRYING TO ACHIEVE?

This should reduce domestic interest ratesand as a result

increase investment in Australia.

This will also act to reduce aggregate demand and thus keep

inflation low. The lower levels of demand should also reduce importsand

improve the current account.

Until 2008 the Government did not consider unemployment

to be ahigh priority.

They believe that investment and business growth will bring a

reduction in unemployment.


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THE GFC and the Budget

In the second half of2008 the Global Financial

Crisis developed and governments around the

world were faced with deficit budgets.

Taxation revenue declined due to lower incomes.

Welfare payments rosedue to increased

unemployment.

Governments increased government expenditure

to stimulate the economy and to increase economic

growth.


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Package

In light of the global economic financial crisis the

Australian Government decided in October 2008 to

release a $10.4 Billion Stimulus Package to the

economy.The main areas of spending were for the lowest

income recipients eg pensioners.

This is the group that could most be disadvantaged

by the crisis but will also be most likely to spend themoney and as a result have greatest impact on the

economy.

The Government also increased the first home buyers

rebate to stimulate the housing industry.


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October 2008 Stimulus Package

The impact of the fiscal stimulus

package was to:

Pump prime the economy to

increase aggregateexpenditure and increase

economic growth

Boost the housing industry

and associated industries.

It could have added to inflation

and put pressure on interest

rates if the global slowdown was

only short lived.
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The 2011-12 Budget

The 2012-13 underlying cash balance has been

reduced from a deficit of$ 44.4 billion (-3% of GDP)

in 2011-12 to a $1.5 billion surplus (0.1% of GDP)

Wh t i t ill th b d t d fi it


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What impact will the budget deficithave on the economy?

The Budget Deficit will initially increase Aggregate

expenditure, aggregate demand and income in the economy.

This can reduce the impact that the Global recession will have

on GDP and unemployment (at least temporarily).

Although the RBA has employed contractionary M.P. an

increase in G could increase domestic interest rates and as a

result decrease investment in Australia.

An increase in G increases aggregate demand and could

therefore add to inflation.

Wh t i t ill th b d t d fi it


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What impact will the budget deficithave on the economy?

Higher levels of demand could increase imports (i.e.

capital) and therefore add further to inflation.

The Budget will increase the level ofPublic Debt

The government will most likely need to call on overseas

funds which willadd pressure to the CAD.

This could increase Foreign Debt as a % of GDP.

The Budget will have no surplus funds to provide for the

future i.e. areas such as Australias aging population.

a s e re a ons p e ween


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a s e re a ons p e weenthe Commonwealth Budget and

CAD?Fiscal Policyis the main macroeconomic policyinstrument, at this time, due to the Governments emphasison the TWIN DEFICIT THEORY.

This implies that a reduction in the Budget Deficit (PSBR)will lead to a reduction in the Current Account Deficit.

I + G + X = S + T + M

I + (G - T) = S + (M - X)

I + PSBR = S + CAD

If S = I, then a reduction in the Public Sector BorrowingRequirement (PSBR) will reduce the CAD.


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What is the Role of Fiscal Policy in the Economy

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