1. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-1 Chapter 6 Fiscal policy

2. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-2 Learning objectives 1.By what means can fiscal policy be used to eliminate an output gap? 2.Why is there a difference between macroeconomic effects of changes to government expenditure and changes to taxes and transfer payments? 3.What are the three limitations on the ability of fiscal policy to stabilise the economy? 4.How does fiscal policy impact on the distribution of income? 5.What effect will demographic change have on fiscal policy? 6.How is fiscal policy related to the level of public debt?

3. Chapter organisation 6.1Government purchases and planned spending 6.2Taxes, transfers and aggregate spending 6.3Fiscal policy as a stabilisation tool 6.4Contemporary fiscal policy Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-3

4. Fiscal policy Two main components of fiscal policy are: –government purchases –taxes and transfer payments. Fiscal policy is designed and implemented by the government to achieve a pre-determined level of output in the economy. The Keynesian model is a simple analytical framework that shows how changes in fiscal policy can alter output in the economy. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-4

5. Government purchases and planned spending Intuition: –As government purchases of goods and services is a component of planned aggregate expenditure ( PAE ), deficiencies in PAE can be compensated with changes in government spending. Government expenditure is exogenous, therefore changes in G will shift the PAE line. –Contractionary gaps: An increase in G will shift PAE up and increase the level of actual output. –Expansionary gaps: A decrease in G will shift PAE down and decrease the level of actual output. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-5

6. Example: Government purchases and contractionary gap Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-6 Figure 6.1 An increase in government purchases eliminates a contractionary gap

7. Example: Fiscal stimulus packages and the GFC Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-7 Figure 6.5 The use of fiscal policy to fight the crisis

8. Chapter organisation 6.1Government purchases and planned spending 6.2Taxes, transfers and aggregate spending 6.3Fiscal policy as a stabilisation tool 6.4Contemporary fiscal policy Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-8

9. Taxes, transfers and aggregate spending Fiscal policy can also take the form of changes to the level and types of taxes and transfer payments in the economy. –These payments are not for the purchases of current goods and services, and are not part of G. Therefore, these changes do not affect PAE directly. Taxes and transfer payments affect the level of disposable income, (Y – T), received by the private sector. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-9

10. Taxes, transfers and aggregate spending (cont.) Effects of changes to taxes and transfers on planned aggregate expenditure: –Tax cuts and increases in transfer payments increase disposable income and raise planned aggregate expenditure. –Tax increases and decreases in transfer payments decrease disposable income and reduce planned aggregate expenditure. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-10

11. Example: Tax cut and contractionary gap Suppose the exogenous spending of 950 results in a contractionary gap of 50 units. PAE = C d + I P + G + X = C – T + I P + G + X + c(1 – t)Y If c = 0.85 and the tax rate, t = 0.6, and we know the coefficient in front of Y is 0.8: PAE = C d + I P + G + X + 0.8 Y = 950 + 0.8 Y Y = 4750 at equilibrium Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-11

12. Example: Tax cut and contractionary gap (cont.) Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-12 Figure 6.6 A cut in the tax rate can eliminate a contractionary gap

13. Balanced budget multiplier Balanced budget multiplier is a situation in which an exogenous increase in transfer payments by the government was matched by a cut in government spending, leaving the budgetary position unchanged. Will output remain unchanged in the case of a balanced budget multiplier? The exogenous increase in payments to households will be spent according to their marginal propensity to consume, c. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-13

14. Example: Baby bonus Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-14 Figure 6.7 The effect of the baby bonus on PAE

15. Chapter organisation 6.1Government purchases and planned spending 6.2Taxes, transfers and aggregate spending 6.3Fiscal policy as a stabilisation tool 6.4Contemporary fiscal policy Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-15

16. Three qualifiers to using fiscal policy as a stabilisation tool In reality there are complexities in the real world in using fiscal policy to try to precisely change output, including: –fiscal policy and the supply side –the problem of deficits –the fact that fiscal policy is relatively inflexible. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-16

17. Fiscal policy and the supply side Fiscal policy affects potential output as well as planned aggregate expenditure. Government spending, G, on public capital such as roads, airports and schools play a major role in the growth of potential GDP. Taxes and transfer payments play a role in affecting incentives and therefore economic behaviour. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-17

18. The problem of deficits Expansionary fiscal policy leads to deficits. It has been suggested that governments need to avoid large and persistent deficits. –Deficits reduce the level of national saving, which reduces investment in new capital goods, an important source of long-run economic growth. This makes increasing spending or cutting taxes a less attractive option. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-18

19. Fiscal policy is relatively inflexible Fiscal policy needs to act swiftly as output gaps arise. –However, changing government spending or taxes is subjected to political process. –The government budget sets out planned government spending and taxes each year. It is handed down in May and can take months to take effect. Governments have agendas beyond stabilising aggregate expenditure. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-19

20. Fiscal policy as a stabilisation tool The qualifications for using fiscal policy to stabilise the economy mean that aggregate spending is more usually stabilised using monetary policy rather than fiscal policy. However, fiscal policy still plays two important roles in stabilising output: 1.Taxes and transfer payments act as automatic stabilisers to the economy. 2.Fiscal policy is useful in dealing with prolonged recessions. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-20

21. Automatic stabilisers Automatic stabilisers are legal provisions linking changes in government spending and taxes to output gaps: –As GDP declines, the level of taxes paid falls and the level of transfer payments made increase, because household incomes decrease. –As GDP increases, the level of taxes paid increases and the level of transfer payments made decrease, because household incomes increase. This happens automatically, without special government action. This makes contractions and expansions in GDP smaller than they would have been otherwise. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-21

22. Expansionary fiscal policy Fiscal policy is still useful in dealing with prolonged recessions Examples in history: –The Great Depression of the 1930s –The Japanese recession of the 1990s –The global financial crisis in 2008 Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-22

23. Chapter organisation 6.1Government purchases and planned spending 6.2Taxes, transfers and aggregate spending 6.3Fiscal policy as a stabilisation tool 6.4Contemporary fiscal policy Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-23

24. Contemporary fiscal policy Fiscal policy plays an important role in the economy, even though stabilising the economy is not one of them. Three key roles of fiscal policy in Australia today are: 1. affecting income distribution 2. responding to demographic change 3. managing public debt. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-24

25. The distribution of income A key function of fiscal policy is to influence the distribution of income between households in the economy. This is done through influencing the total disposable income available to households, which is done through net taxes. Net taxes are the difference between tax paid by a household and transfer payments received. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-25

26. Progressive taxes and transfer payments Australia has a system of progressive income taxes. –The higher the income earned by the household, the relatively higher proportion of tax is paid on that income. –That is, the proportion of income paid as tax is higher at higher income levels. The result is a less unequal distribution of income. Government transfer payments are targeted toward low income earners. –These payments also narrow the gap that would otherwise be much larger. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-26

27. Example: Progressive taxes Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-27 What is your income tax liability if your earn $120 000? What if $60 000? TABLE 6.2 Income tax rates in Australia, 2009/2010

28. Relative income inequality We can get an indication of relative income inequality through the use of Gini coefficients and Lorenz curves. –A Lorenz curve is a graphical representation of income inequality. –A Gini coefficient is a summary measure of income inequality. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-28

29. Example: Two hypothetical income distributions Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-29 TABLE 6.3 Two hypothetical income distributions

30. Example: Two hypothetical income distributions (cont.) Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-30 Figure 6.9 Lorenz curves

31. Gini coefficient The cumulative numbers for the two distributions are then compared to a perfectly equal distribution: –The bottom 20% of the population would earn 20% of the total income; the bottom 40% of the population earning 40% of the income, etc. This line is drawn on the graph, and the Gini coefficient can be calculated as: area between the line of equality and the Lorenz curve Gini = total area below the line of equality Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-31

32. Example: Two hypothetical income distributions (cont.) In the earlier hypothetical income distributions –For income distribution A: Gini = 0.274 –For income distribution B: Gini = 0.048 In general, the lower the value, the closer the Lorenz curve to the line of equality, and the more equal the distribution. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-32

33. Income inequality over time Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-33 TABLE 6.4 Selected Gini coefficients

34. Managing demographic change Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-34 Figure 6.10 Projections of Australian government spending (real spending per person, 2009–2010 dollars)

35. Tax revenue Tax revenue is difficult to forecast as it depends on a number of different aspects such as level of expenditure in the economy (will alter GST payable), the level of business profits (business income tax), the tax rate, as well as the number of taxpayers. Despite this, it is assumed that government revenue as a proportion of GDP will stay the same at about 22%. Projection sees large deficits from about 2025 onwards. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-35

36. Projected budget balances Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-36 Figure 6.11 Projected primary budget balances

37. Fiscal policy and the public debt Governments have three possible ways they can finance their spending: 1.They can raise taxes, T t. 2.They can borrow money. 3.They can simply print money to finance their spending. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-37

38. Government budget constraint –Government spending comprises government expenditure in a time period, G t and transfer payments Q t. –Let B t – 1 be the stock of securities the government has owing at the end of the previous period. Any new borrowing in the period t means that B t – B t – 1 > 0. This also means there is a third expenditure every period, which is the interest paid on its stock of debt, rB t – 1, where r is the real rate of interest. –Therefore, the spending that needs to be undertaken in the period by the government which needs to be financed by some method is: G t + Q t + rB t – 1 = T t + (B t – B t – 1 ) Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-38

39. Increasing and decreasing public debt We can rearrange this equation with gross taxes on the left-hand side: G t + Q t – T t + rB t – 1 = (B t – B t – 1 ) –When the government runs a deficit budget, the left-hand side is positive and we will be adding to the stock of public debt. –When the government runs a surplus budget, the left-hand side is negative and the stock of debt will fall. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-39

40. Benefits of low public debt Low levels of public debt are desirable to reduce crowding out, which is government borrowing increasing interest rates and therefore decreasing investment. Borrowing because of deficit budgets can’t be sustained forever, and eventually surpluses would be required to reduce debt. –Intergenerational equity means we should not enjoy the benefits of budget deficits now and pass on the costs of those deficits to future generations. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-40

41. Benefit of public debt Public debt can also have a net benefit for the economy, even when allowing for crowding out and intergenerational equity effects. This is when important infrastructure projects are financed through public debt. –Such projects have been estimated to add 0.4% p.a. to productivity for every 1% increase in public spending. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-41

42. Chapter organisation 6.1Government purchases and planned spending 6.2Taxes, transfers and aggregate spending 6.3Fiscal policy as a stabilisation tool 6.4Contemporary fiscal policy Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-42

43. Summary Fiscal policy involves the government deciding on the level of spending, taxes and transfer payments. Fiscal policy is used to: –stabilise output gaps in the short run –redistribute income –handle demographic change –manage public debt Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-43

44. Summary (cont.) Expansionary fiscal policy –Increasing government spending shifts the PAE function –Decreasing tax rate pivots the PAE function Criticisms of fiscal policy –Overly supply-side driven –Mounting public debt –Subjected to lengthy political process Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 6-44