Fiscal Policy
What is the formula for the multiplier?
change in equilibrium real GDP / change in autonomous expenditure
What is the formula for the government purchases multiplier?
change in equilibrium real GDP / change in government purchases
What is the formula for the tax multiplier?
change in equilibrium real GDP / change in taxes
Crowding out
A decline in private expenditures as a result of an increase in government purchases
Fiscal policy
Changines in federal taxes and purchases that are intended to achieve macroeconomic policy objectives, such as high employment, price stability and healthy rates of economic growth
Induced expenditure
Expenditure that depends on the level of GDP
Why would crowding out reduce economic growth?
Increases in interest rates reduce investment, which is likely to reduce economic growth
Contractionary fiscal policy
Involves decreasing government purchases or increasing taxes in order to reduce aggregate demand
Suppose that real GDP is currently 13.1 trillion, potential GDP is $13.5 trillion, the government purchases multiplier is 2 and the tax multiplier -1.6. Holding other factors constant, by how much will taxes have to be cut to bring the economy to equilibrium at potential GDP?
tax multiplier = change in equilibrium in real GDP/ change in taxes 400/-1.6 = -250 billion Will decrease $0.25 (250 billion) trillion in tax
Marginal propensity to consumer (MPC)
the amount by which consumption changes when disposable income changes
How might an expansionary monetary policy affect the extent of the crowding out in the long run?
An EMP would decrease interest rate and thus, reduce the extent of the crowding out
Identify the following as being part of an expansionary fiscal policy; contractionary fiscal policy or not part of fiscal policy: a) the company income tax is increased
Contractionary: because trying to decrease spending through increased tax rate
Budget surplus
The situation in which the government's expenditures are less than its tax revenue
The federal government's budget was in surplus by almost $20 billion in 2007/08 and in deficit by over $44 billion in 2011/12. What does this information tell us about fiscal policy actions taken by the government during these years?
During the 2000s until 2007/2008 Australian economy was booming. It was operating at a surplus. Huge surpluses usually indicate a contractionary policy because it means the government is not spending the money. However in this case, it was mainly due to automatic stabilisers rather than discretionary fiscal policy. The budget deficit indicate an expansionary policy by which the government dramatically increase government purchases. This was designed to limit the negative effects of the GFC. Part of the deficit was also due to automatic stabilisers reducing the governments tax revenue and increasing its transfer payments.
What is expansionary fiscal policy and under what circumstances would it be used?
Expansionary fiscal policy involves increasing government purchases or reducing taxes to stimulate aggregate demand. It would be used when the economic growth rate is becoming low or if the economy is in a recession.
Identify the following as being part of an expansionary fiscal policy; contractionary fiscal policy or not part of fiscal policy: d) the personal income tax rate is decreased
Expansionary fiscal policy.
Supply side policies
Fiscal policies that have long run effects by expanding the productive capacity of the economy and increasing the rate of economic growth. These policy actions primarily affect aggregate supply. Increased productivity through new technology and education, increasing size of labour force, increase efficiency
Identify the following as being part of an expansionary fiscal policy; contractionary fiscal policy or not part of fiscal policy: e) the state of NSW builds a new highway in an attempt to expand employment
Fiscal policy refers only to the actions of the federal government. Therefore, not a part of fiscal policy
Suppose that real GDP is currently 13.1 trillion, potential GDP is $13.5 trillion, the government purchases multiplier is 2 and the tax multiplier -1.6. Holding other factors constant, by how much will government purchases need to be increased to bring the economy to equilibrium at potential GDP?
G = change in real GDP/multiplier = 400 billion/2 = 200 billlion or 0.2 trillion
Explain how 'governments' thirst for funds could lead to crowding out?
Government borrowing increases demand for funds, causing interest rates to rise
Automatic stabilisers
Government spending and taxes that automatically increase or decrease along with the business cycle
In what ways does the federal budget serve as an automatic stabiliser for the economy?
In the contraction phase of the business cycle or recession, households and firms pay less taxes to the federal government and the federal government makes more transfer payments. This is a stimulus to the economy. In the expansion phase of the business cycle or boom, households and firms pay more taxes and the federal government makes fewer transfer payments. This slows down the economy.
Explain how the federal budget can serve as an automatic stabiliser.
In the contraction phase of the business cycle or recession, households and firms pay less taxes to the federal government and the federal government makes more transfer payments. This is a stimulus to the economy. In the expansion phase of the business cycle or boom, households and firms pay more taxes and the federal government makes fewer transfer payments. This slows down the economy. The automatic movements in the federal budget help to stabilise the economy by cushioning the fall in spending during recessions and restraining the increase in spending during expansions.
Describe the difference between crowding out in the short run and in the long run.
In the short run, an increase in government purchases may not fully crowd out private expenditures due to the stimulative effect of an increase in government purchases on aggregate demand. In the long run, most economics believe that a permanent increase in government purchases will result in complete crowding out of private expenditures
Is government debt bad for the economy?
In times of a recession, governments often operate a deficit budget, as part of expansionary fiscal policy. If effective, it can reduce short-term fluctuations in the business cycle. Deficits can occur in the short-run if the government is spending on improved infrastructure, which will lead to increases in economic growth and productivity in the future. However, debt has an opportunity cost, as current interest repayments are funds that could be used for something else. It imposes a greater tax burden on future generations, as the interest and the initial debt must be paid. Greater taxation in the future will reduce consumption and can dampen economic growth in the future.
In terms of its effect on the long run growth rate of real GDP, would it matter if the additional government spending involves (i) increase spending on highways and bridges or (ii) increased spending on national parks? Briefly explain?
Increased spending on highways and bridges may promote economic growth, whereas increased spending on national parks i unlikely to (although there may be a small effect on the tourism industry)
Some economists argue that because increases in government spending crowd out private spending, increased government spending will reduce the long run growth rate of real GDP. Is this most likely to happen if the private spending being crowded out is consumption spending, investment spending or net exports? Briefly explain?
Investment spending: because accumulating more machinery, equipment and structures are necessary for economic growth Private companies want to invest but they can't
Expansionary fiscal policy
Involves increasing government purchases or decreasing taxes in order to increase aggregate demand
Which can be changed more quickly: monetary policy or fiscal policy? Briefly explain.
Monetary policy can be changed more quickly. The reserve bank board can make changes at any of its monthly meetings or more frequently if need be. Fiscal policy has to go through the legislative process of the parliament approving a fiscal policy action. Even once approved, it takes time to implement the fiscal policy change.
Identify the following as being part of an expansionary fiscal policy; contractionary fiscal policy or not part of fiscal policy: b) defence spending is increased
Not part of fiscal policy. Any actions that are not intended to achieve macroeconomic goals, there are not a part of fiscal policy. This is an increase in defense spending only
Identify the following as being part of an expansionary fiscal policy; contractionary fiscal policy or not part of fiscal policy: c) families are allowed to deduct all their expenses for child care from their taxable income
Not part of fiscal policy. Not directly aimed at achieving macroeconomic goals Unless it is a change to existing policy to stimulate spending.
Discuss the difficulties that can arise in implementing fiscal policy
Poorly timed fiscal policy can do more harm than good. Because an increase in government purchases may lead to a higher interest rate, it may result in a decline in consumption, investment, and net exports. A decline in private expenditures as a result of an increase in government purchases is called crowding out. Crowding out may cause an expansionary fiscal policy to fail to meet its goal.
Budget deficit
The situation in which the government's expenditures are greater than its tax revenue
Cyclically adjusted budget deficit or surplus
The deficit or surplus in the federal government's budget if the economy were at potential GDP
Explain how the multiplier process works with respect to fiscal policy
The multiplier effect refers to the fact that an increase in government purchases or a cut in taxes will have a multiplied effect on equilibrium real GDP. Increases in government purchases and cuts in taxes have a positive multiplier effect on real GDP. Decreases in government purchases and increases in taxes have a negative multiplier effect on real GDP.
Multiplier effect
The process by which an increase in autonomous expenditure leads to a larger increase in real GDP - The series of induced increased in consumption that results from an initial increase in autonomous expenditure
Multiplier
The ratio of the increase in equilibrium real GDP to the increase in autonomous expenditure
Discuss whether you think government debt is a good or bad thing.
This can be a good thing if it is temporary - as it can soften the effects of a contraction or recession and reduce the increase in unemployment. This can be a bad thing if debt occurs frequently when the economy is not in a recession, it can be a problem; will impose lower economic growth and lower spending in the future, as taxes must be raised to pay the interest repayments on the debt. If debt becomes large as a proportion of GDP, this then becomes a very serious problem
Why does a $1 increase in government purchases lead to more than a $1 increase in income spending?
Through the government purchases multiplier, the $1 increase in government spending will lead to an increase in aggregate demand and national income, which will lead to an increase in induced spending
Explain how fiscal policy affects GDP and how the government can use fiscal policy to stabilise the economy
To fight recessions, the government can increase government purchases or cut taxes. This expansionary policy results in an increase in real GDP (and the price level). To fight rising inflation, the government can decrease government purchases or raise taxes. This contractionary policy causes reduces real GDP (and the price level).
During the mid-2000s the Aus fed government operated successive budget surpluses that were approximately 1% of GDP. Does this mean that it was operating contractionary fiscal policy during this time? Discuss
When receipts are greater than expenditure, this may indicate contractionary fiscal policy. However, during the mid-2000s, Australian economy was booming and surpluses were largely the result of automatic stabilisers rather than discretionary fiscal policy. in fact, the government was reducing personal income taxes during this time to partly offset the effect of automatic stabilisers and in part as a supply-side policy
Discretionary fiscal policy
When the government is taking actions to change spending of taxes to achieve its economic objectives (fiscal policy)
If the government does not change fiscal policy during the business cycle, will there be any forces that will help smooth out economic fluctuations?
Yes there are. Even if government does not actively change fiscal policy, these automatic stabilisers can help out economic fluctuations. In the absence of exercising discretionary fiscal policy the use of MP can also be used to smooth or moderate the effects of economic fluctuations. During an economic contraction or recession, the existence of unemployment benefits and other forms of social security means incomes of people do not fall by as much as they otherwise would, while income tax revenue fall due to the progressive nature of income tax scales. During an economic expansion or boom, income tax revenues rise due to the progressive income tax scales
Construct an example of a combination of increased government spending and tax reduction.
cut tax by 125 billion (half) = 200 billion cut gov exp by 100 billion (half) = 200 billion = 400 billion
Autonomous expenditure
expenditure that does not depend on the level of GDP