Fiscal Policy How the Government affects my money! Because the government is so large and has such an impact on business, the decisions it makes has a

Fiscal Policy

How the Government affects my money!

Because the government is so large and has such an impact on business, the decisions it makes has

a HUGE influence on the economy.

The Federal Reserve (another government agency) DOES NOT make fiscal policy. We will discuss the

Federal Reserve next class.

Federal Government Finance• Federal expenditures

– large expenditure on social security and welfare– specific purpose grants

• Federal revenues– Personal income tax– Company income tax– Indirect and other taxes

• GST• excise tax

Copyright 2004 McGraw-Hill Australia Pty Ltd

PPTs t/a Macroeconomics 7/e by Jackson and McIver

Slides prepared by Muni Perumal, University of Canberra, Australia

9-2

Discretionary Fiscal Policy

• The deliberate manipulation of taxes and spending by government for the purpose of altering real GDP and employment, controlling inflation and stimulating economic growth

• Not all fiscal policy is deliberate




9-3

Expansionary and Contractionary Fiscal Policy: Changes in Government Spending, Panel (a)

If there is a recessionary gap in panel (a), fiscal policy can presumably increase aggregate demand

Expansionary Fiscal Policy

• Increased government spending or lower taxes or increased transfer payments (social security payments) to reduce the effects of recession, i.e. boost GDP and reduce unemployment




9-5

Decreasing Taxes

1. Gives people more money to spend2. More money = more demand3. More demand = more production4. More production = more jobs5. More jobs = more demand etc. etc.

Increase Spending

1. Increases demand for goods 2. More demand = more production3. More production = more jobs4. More jobs = more demand etc. etc.

Expansionary Fiscal Policy




9-8

ASLS

Qp

Pric

e le

vel

Real gross domestic product

AS1

AD2

Q1

AD1

P1

Q2

P2

Contractionary and Expansionary Fiscal Policy: Changes

in Taxes, Panel (a)

• In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibrium

• Contractionary fiscal policy can move aggregate demand to AD2 via a tax increase

• A new equilibrium is at E2 at a lower price level

• Real GDP is now consistent with LRAS

Contractionary Fiscal Policy

• Decreased government spending or higher taxes or a reduction in transfer payments in order to reduce inflation during a boom




9-10

Increase Taxes

1. People have less money to spend2. Less money = less demand3. Less demand = lower inflation

Decrease Spending

1. Less money in economy2. Less money = less demand3. Less demand = lower inflation

Contractionary Fiscal Policy




9-13

ASLS

Qp

Pric

e le

vel

Real gross domestic product

AS1

AD1

Q1

AD2

P1

P2

Contractionary and Expansionary Fiscal Policy: Changes

in Taxes, Panel (a)

• In panel (a), the economy is initially at E1, where real GDP exceeds long-run equilibrium

• Contractionary fiscal policy can move aggregate demand to AD2 via a tax increase

• A new equilibrium is at E2 at a lower price level

• Real GDP is now consistent with LRAS

Non-Discretionary Fiscal Policy• Built-in or automatic stabilisers that operate without

requiring explicit action by policy-makers, they are the result of a progressive income taxes and a social security system

• During recessions: Tend to increase government deficits (or reduce surplus) through lower taxes and higher welfare payments

• During inflationary periods: Tend to increase government surpluses (or reduce deficits) through higher taxes and lower welfare payments




9-15

Automatic or Built-in Stabilisers

• Tax receipts: Increase as real GDP increases, so the economy slows

• Transfers: Decrease as real GDP increases, but increase when the economy slows so GDP and AD increase.

• Do not fully correct the economy, only reduces the severity of fluctuations

• Useful when economy is operating around full employment

• Can cause problems: Fiscal DragCopyright 2004 McGraw-Hill Australia

Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson

and McIverSlides prepared by Muni Perumal, University of Canberra, Australia

9-16

Automatic or Built-in Stabilisers




5-17

Le

vel o

f b

usi

ne

ss a

cti

vit

y

Time

Flatten out the fluctuations in the business cycle, but do not eliminate them completely

Problems with Fiscal Policy in Practice

• Problems of timing– Recognition lags– Administrative lags– Operational lags

• Political problems– Other economic goals, economic growth

complements and conflicts with other policies– Expansionary bias, often not used stimulate rather

than slow the economy– The political cycle may accentuate the business cycle.




9-18

Crowding-Out Effect

– The tendency of expansionary fiscal policy to cause a decrease in planned investment or planned consumption in the private sector; this decrease normally results from the rise of interest rates.

The Crowding-Out Effect, Step by Step

The Crowding-Out Effect

Expansionary policy causing deficit spending initially shifts from AD1 to AD2

Due to crowding out, AD shifts inward to AD3

Equilibrium GDPbelow full-employment GDP—recessionary gap

The supply-side effects of changes in taxes

– Expansionary fiscal policy could involve reducing marginal tax rates.

• Advocates argue this increases productivity since individuals will work harder and longer, save more, and invest more.

• The increased productivity will lead to more economic growth.

Supply-Side Economics

– The suggestion that creating incentives for individuals and firms to increase productivity will cause the aggregate supply curve to shift outward

Laffer Curve

Tax rates andtax revenuesrise together

Tax revenues are at a maximum

Tax rates and tax revenues fall together

Documents

Fiscal Policy How the Government affects my money! Because the government is so large and has such an impact on business, the decisions it makes has a