1. Fiscal Policy Macroeconomic Policy in the Asia-Pacific GECO6400
Slide 1
Fiscal Policy

2. FISCAL POLICY This Week The Public Sector Fiscal Policy explained
Fiscal Policy and the Aggregate Expenditure Model
The Government Budget
Discretionary Fiscal Policy
Non-Discretionary Fiscal Policy
Budget Outcomes
Public debt.
Offer an evaluation of efficacy of fiscal policy.
We will compare budget outcomes in various countries.

3. FISCAL POLICY The Public Sector
All entities owned &/or controlled by Federal, state or local governments The Public Sector forms the 3rd macroeconomic sector in the circular flow of income. The macroeconomy is no longer a private macroeconomy but a public one. The public sector is made up of all levels of government (federal, state and local) and government institutions and enterprises. They have a significant impact on macroeconomic activity. The federal government has the greatest impact due to its size and scop of operations and influence, both financially and legislatively.

4. FISCAL POLICY The Public Sector
The Public sector generally fulfills three broad functions within an economy:
Resource Allocation
Dealing with externalities
Funding public goods (health, education, defence etc.)
Regulating natural monopolies (railways, water and electricity supply and pricing)

5. FISCAL POLICY Income Redistribution
minimum standard of living (transfer payments such as disability pensions, UB, etc).
Taking from the better-off citizens and giving it to the less well-off through progressive income tax, capital gain tax etc.
Output Stabilisation
Aim to facilitate growth and reduce the amplitude of business cycle simultaneously.
Stabilisation goals (inflation & unemployment) Government expenditure has multiplier effect

6. FISCAL POLICY
In this Lecture we are concerned with Stabilisation Policy only and not with Allocation or Income distribution functions of the Government
The Public Sector and Fiscal Policy
Fiscal policy is the Public Sector’s management of its revenue and expenditure.
It is the financial side of policy implementation.
The government has at its disposal the taxes it collects and debt it raises to spend.
It then uses these to finance its expenditure programs.

7. FISCAL POLICY The Federal Budget
The Federal Budget sets out the expected revenue and expenditure flows within a period of time. Reviews the past performance of the economy. Forecasts the key macroeconomic variables. Sets out the policy changes and their policy implications

8. FISCAL POLICY The budget outcome is calculated as:
Revenue - Expenditure
Tax revenue:
Lump sum taxes (e.g poll tax)
proportional taxes (GST)
progressive taxes (income taxes).
Federal Government Expenditure:
Current expenditure.
Capital expenditure.
Transfer payments (aged pensions, current transfers and grants to the states).

9. Fiscal Policy and the Aggregate Expenditure Model
Government expenditure is treated like Investment & Export expenditure (injection into the economy). AE=C+I+G Taxation is treated like Saving and Imports (leakage out of the economy). Leakages=S+T Injections=I+G

10. Numerical Example: T = 200 + 0.4Y
FISCAL POLICY
Tax Revenue (T)
T are partially induced since income taxes are function of Real GDP (Y).
General Form: T=TA + tY
where: TA = lump sum taxes
t = marginal tax rate
Numerical Example: T = Y
Government Expenditure (G)
G is assumed autonomous since it is a function of Budgetary Policy decisions.
General Form: G= GA
Numerical Example: G = 1000

11. FISCAL POLICY
Government Expenditure and Taxation can be represented on the leakages-injections diagram (similar to Investment and Savings)
T= Y
G and T
G=$1,000
200
OUTPUT

12. FISCAL POLICY Budget Outcomes
Balanced Budget: revenue equals expenditure.
G=T
Slightly Expansionary. Balanced Budget Multiplier (not neutral).
Budget surplus: revenue is greater that expenditure.
Government earns more than it spends. Government is saving.
G<T
Contractionary.
Budget deficit: outlays are greater than revenue. Government spends more than it earns.
G>T
Expansionary.

13. FISCAL POLICY
Taxes are a leakage from the circular flow Therefore this impacts on the size of the multiplier. Expenditure multiplier is now 1/MPS+t. Note, savings are also affected by tax.

14. FISCAL POLICY G and T T>G Budget Surplus G>T Budget Deficit
Balanced Budget
T = Y
1000
G = 1000
200
Real GDP (Y)
-800
Budget Outcome
T - G

15. Impact of a Budget Surplus
FISCAL POLICY
Impact of a Budget Surplus
A budget surplus is contractionary in an income-generating sense because the government takes more money out of the Circular Flow of Income than it puts in. A budget surplus causes economic activity, employment and inflation to decline.

16. FISCAL POLICY
Financing a Budget Deficit The excess of expenditure over revenue means that a the government needs to source extra funding for its activities. It can do this in 2 ways: Debt Financing By borrowing from the public (getting into debt). Government borrowing is done by selling IOUs (bonds) to the general public. The buyer of the bonds (the Reserve Bank of Australia or the private sector) determines the nature of the finance obtained.

17. FISCAL POLICY
Monetising the Deficit Printing more money (via the mint). When the bank buys bonds from the government, it uses newly-created money to do so. This newly-created money flows back into the banking system in the form of an increase in the monetary base. An increase in MS causes an increase in AD. Higher AD leads to an increase in the price level.

18. FISCAL POLICY
Monetising the Deficit Persistent money financing of a budget deficit leads to continuous increases in AD and to inflation. This can be more expansionary than debt financing because more money is created and can support more macroeconomic activity.

19. FISCAL POLICY Monetising the Deficit
BUT, the Reserve Bank must accommodate the increased money in the economy by at least maintaining the general level of interest rates; or
This can lead to a rise in inflation (demand-pull).
G increases, but there is no real change in GDP because there is more money but no change in the output of goods and services.

20. FISCAL POLICY
Discretionary Fiscal Policy This is the government’s deliberate regulation of its budget to attempt to smooth out business fluctuations (to ensure maximum employment and low inflation). The government takes advantage of the impact that the budget outcome has on economic activity and uses this to achieve its policy aims. Policy aims: high economic growth (GDP), low prices (inflation), low unemployment. Eliminate or reduce Inflationary or deflationary gaps

21. FISCAL POLICY
Deflationary gap: when potential GDP is greater than actual GDP. The government should pursue an expansionary fiscal policy to eliminate the gap. Inflationary gap: when potential GDP is less than actual GDP. The government should dampen the economy through contractionary fiscal policy.

22. Actual, Structural and Cyclical Budgets
FISCAL POLICY
Actual, Structural and Cyclical Budgets
Types of Budget Outcomes Actual: the basic outcome of the budget. Structural: the budget outcome that would occur at full employment or potential output. The structural budget outcome indicates the type of discretionary fiscal objective being sought by the government. Cyclical: the actual budget outcome minus the structural budget outcome. This is influenced by economic activity.

23. Actual, Structural and Cyclical Budgets
FISCAL POLICY
Actual, Structural and Cyclical Budgets
The actual budget outcome can be expressed as:
BA=BC+BS
The structural budget is achieved at potential GDP. It is calculated as the Actual budget outcome less the Cyclical budget outcome:
BS=BA-BC
The cyclical budget outcome is equal to the actual budget outcome less the structural budget outcome:
BC=BA-BS

24. FISCAL POLICY Take our example: T=200+0.4Y and G=2000
Now if actual GDP=3000
Actual Budget outcome is:
T-G = (3000)-2000
= = -600 ~ deficit
The stance of Fiscal Policy, judging from this budget outcome, looks expansionary.

25. FISCAL POLICY
But let Potential GDP=5000 Structural budget outcome is: T-G= (5000)-2000 = = +200 ~ surplus The stance of Fiscal Policy, judging from this budget outcome, looks contractionary.

26. FISCAL POLICY The Cyclical budget outcome is: T-G= actual – structural
= = -800
Actual economic activity is lower that potential economic activity, therefore the government’s taxation revenue falls short of its budgeted level because this is based on potential GDP.
Taking into account the state of the economy, the budget needs to be more expansionary than it actually is.
That is, the government needs to increase its expenditure (G) or reduce taxation (T) to get the economy to its full potential.

27. FISCAL POLICY YE=$3,000B Actual Budget Outcome $600B DeficitAE AE
YE=$3,000B
Actual Budget Outcome
$600B Deficit
YP=$5,000B
Structural Budget Outcome
$200B Surplus
Cyclical Budget Outcome
Actual-Structural
$800B Deficit
Equilibrium GDP
45o
3000
Real GDP T
T&G
Budget Surplus G
Budget Deficit
LRAS
Real GDP
SAS
Price AD
3000
5000
Real GDP

28. Non-Discretionary Fiscal Policy
Automatic Stabilisers Automatic stabilisers take some of the discretion out of the budget outcome. Automatic Stabilisers are institutional factors that are set up by the government for various reasons (such as equity or to provide a revenue base for budgetary activity). Once they are in place, they act counter-cyclically to influence the outcome of the budget – they influence government revenue and expenses. Again, the emphasis is on income influencing macroeconomic behaviour in a counter-cyclical way.

29. 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) Examples of Automatic Stabilisers Progressive Income Tax: as income increases, so does the leakage of tax, reducing the impact of increased income on spending. Transfer payments: eg unemployment benefits. As income declines, transfer payments increase, boosting AD and keep the economy buoyant.

30. As GDP increases the Budget moves from DEFICIT into SURPLUS.
FISCAL POLICY
Automatic Fiscal Stabilisers
Budget Outcome
G and T
Budget Outcome
T - G
-800
Real GDP (Y)
As GDP increases the Budget moves from DEFICIT into SURPLUS.

31. FISCAL POLICY Fiscal Drag
Suppose the economy has found equilibrium at less than full employment. Any attempts to stimulate the economy will be muted by the operation of the automatic stabilisers. This is fiscal drag. For example, increase Government spending by $300 with multiplier of 2. Change in Ye will be $600 but if MPT = 0.4, then tax revenues will increase & dampen Ye by $240. Cure: Appropriate discretionary fiscal policy

32. FISCAL POLICY
Summary
The Actual budget outcome in any given year does not necessarily indicate the government’s true fiscal stance. The presence of automatic stabilisers means that the actual budget outcomes are sensitive to the level of GDP. To determine stance (expansion or contraction) of budget look at the Structural budget outcome (what is would be at potential GDP).

33. FISCAL POLICY
Potential
GDP
Real

34. FISCAL POLICY Evaluating FP
Crowding out Crowding out occurs when the government competes with the private sector for funds to finance a budget deficit. The competition for funds causes an increase in demand for money and hence interest rates. This slows down growth.

35. FISCAL POLICY Fiscal Policy Transmission Mechanism and Crowding Out
Domestic Crowding Out
G  AE  Y  MD  IR  I  AE   Y
International Crowding Out
Overseas Sector:
IR   D$A   ER  NX   AE   Y

36. FISCAL POLICY Fiscal Policy Transmission Mechanism and Crowding Out G
AE  Y 
MD 
IR  I 
AE 
 Y
Aggregate Expenditure Model
Money Market
Investment Demand AE IR MS IR
AE1
IR1
AE2
AE0
IR0 ID
MD1
MD0 Y0 Y2 Y1
Real GDP QM I1 I0 I

37. FISCAL POLICY Evaluating FP Net Export Effect
The impact of interest rate-induced change in the exchange rate, and thus net exports, following changes in fiscal policy.
Freely-floating exchange rate system.
Expansionary Fiscal Policy
Results in higher interest rates. This increases the demand for the $A leading to its appreciation and a decline in net exports, a reduction in AE and a fall in GDP.

38. FISCAL POLICY Evaluating FP
Net Export Effect Contractionary fiscal policy Results in lower interest rates. This reduces the demand for the $A leading to its depreciation and an increase in net exports, an increase in AE and an rise in GDP. The Net Export Effect, with a freely-floating exchange rate, reduces the overall impact of fiscal policy on economic activity.

39. FISCAL POLICY Evaluating FP Crowding out and the Net Export Effect
Investment
Budget Outcome
Interest Rates
Aggregate Demand
Exchange Rate
Exports

40. FISCAL POLICY Evaluating FP
Budget Deficits and Aggregate Demand A Budget Deficit shifts AD to the right. This increases output and prices The full impact of FP will depend on price elasticity of SRAS. The more price elastic is AS, the greater will be the impact on Y with smaller rise in price level.

41. Effects of Expansionary Fiscal PolicyAS
AD2
AD1
Price level P3 P2 Q2 P1 Q1 Q2
Real GDP

42. FISCAL POLICY Evaluating FP
Deficits & Aggregate Supply Supply-siders argue for tax cuts – lower taxes increases disposable income and encourages saving and investment. But they claim alter incentives to work. Evidence on work incentive effects is VERY weak.

43. Supply-Side Effect of FP
FISCAL POLICY
Supply-Side Effect of FP
AS2
AS1
Price level
AD1
AD2 P1 P2 Q2
P3 = Q3 Q1
Real GDP

44. FISCAL POLICY Evaluating FP Lags Problems of timing Recognition lags
Administrative lags
Implementation lags
Political problems
Other economic goals: not just stability
Expansionary bias
A political business cycle

45. FISCAL POLICY Evaluating FP SUMMING UP
FP will be more effective in influencing economic activity if:
Investment is not very responsive to interest rate changes.
International capital flows are not very responsive to domestic interest rates.
SRAS is very price elastic.
Shorter are the policy lags.
Less political interference on policy stance.

46. Budget Strategies: Various Philosophies
FISCAL POLICY
Budget Strategies: 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

47. Budget Strategies: Various Philosophies
FISCAL POLICY
Budget Strategies: Various Philosophies
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)

48. FISCAL POLICY

49. Budget deficit in global perspective
FISCAL POLICY
Budget deficit in global perspective

50. FISCAL POLICY

51. FISCAL POLICY

52. FISCAL POLICY

53. FISCAL POLICY

54. FISCAL POLICY Public Debt
The total accumulation of the Federal Government’s total deficits and surpluses over time
General govt sector net debt as share of GDP went below zero in
Myths about public debt:
Government is going bankrupt
Government can refinance existing debt – saw before that debt really an instrument of monetary policy.
Can create more money
Shifting burdens, future generations will pay for it

55. FISCAL POLICY

56. Problems with Public Debt
FISCAL POLICY
Problems with Public Debt
Economic implications
External debt may be a problem
Increased taxes may dampen incentives - but saw before no necessary link between money, debt & taxes.
Income distribution
Government bonds are generally held by those wealthier members of society
Composition important: capital versus consumer goods

57. Problems with Public Debt
FISCAL POLICY
Problems with Public Debt
Some argue there is a crowding-out effect and impact on 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
But in an economy with unemployed resources a government deficit, irrespective of how it is financed, has potential to increase output of both consumption and capital goods for an economy.

58. Public Debt: Positive Role
FISCAL POLICY
Public Debt: Positive Role
Saw before with Paradox of Thrift that if an economy’s saving was not matched by investment (or other injection) that economy would contract.
So borrowing & debt, transfer saving to spenders and thereby play a positive function in maintaining a high level of output and employment.
As well, government debt in the form of bonds offers private sector a low risk interest bearing asset in which to hold their wealth. Important to the depth & confidence of financial markets.

59. FISCAL POLICY References
Jackson & McIver, Chapter 8 McTaggart et al. Ch 25 Kniest, Lee & Burgess, Chapter 11.