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Chapter 10
Fiscal policy and the
public debt
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-1
Learning Objectives
• Briefly outline the nature of federal government
expenditures and revenues.
• Explain how a degree of economic stability is built
into our tax system.
• Survey some basic problems in the application of
fiscal policy.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-2
Learning Objectives (cont.)
• Briefly discuss several contrasting budget
philosophies.
• Assess the quantitative and qualitative aspects of the
public debt.
• Discuss the implications of and complications
associated with fiscal policy within the aggregate
demand–aggregate supply framework.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-3
Federal Government Finance
• Federal expenditures
– large expenditure on social security and welfare
– specific purpose grants
• Federal revenues
– personal income tax
– company income tax
 Double taxation a highly controversial problem
– Indirect and other taxes
 sales tax
 excise tax.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-4
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.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-5
Expansionary Fiscal Policy
• The use of increased government spending and/or
lower taxes, thereby increasing the government
budget deficit, to stimulate economic activity and the
move the economy out of recession or depression.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-6
Contractionary Fiscal Policy
• The use of reductions in government spending and/or
higher taxes, thereby reducing the deficit or
increasing the surplus in the government’s budget, to
control demand-pull inflation.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-7
Financing Deficits
• Effect of an expansionary fiscal policy depends on
the method by which the deficit is financed
– Borrowing: May increase interest rates, thus
‘crowding out’ some investment spending and
some interest-sensitive consumer spending.
– Money creation:
 Deficit financed by the RBA by issuing new
money
 Avoids crowding out of private spending.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-8
Disposing of Surpluses
• Effect of contractionary fiscal policy depends on the
method by which the surplus (or movement towards
surplus) is financed.
– Debt reduction: May reduce anti-inflationary impact of policy
by reducing interest rates, thereby stimulating private
spending.
– Idle surplus (or impounding): when the government
withholds purchasing power.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-9
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).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-10
Automatic or Built-in Stabilisers
• Tax receipts: Increase as real GDP increases.
• Transfers: Decrease as real GDP increases.
• Do not correct; only reduce the severity of
fluctuations.
• Useful when economy is operating around full
employment.
• Can cause problems: Fiscal Drag.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-11
T
{
Government expenditure
and tax revenue ($ billions)
Built-in Stabilisers
Deficit
{
GDP3
GDP1
Surplus
G
GDP2
Real GDP (billions)
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-12
Fiscal Drag
• Occurs when an economy stabilises at an
undesirable output level because of the operation of
automatic stabilisers.
• Over time as an economy grows, this can choke off
growth.
• The cure is: Discretionary fiscal policy.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-13
Cyclically Adjusted Budget
• Indicates what the budget deficit (or surplus) would
be if the economy were to operate at potential output
throughout the year.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-14
Problems with Fiscal Policy in
Practice
• Problems of timing
– recognition lag
– administrative lag
– operational lag
• Political problems
– other economic goals: not just stability
– expansionary bias
– a political business cycle.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-15
Problems with Fiscal Policy in
Practice (cont.)
• Crowding-out effect
– When an expansionary fiscal policy tends to
increase the interest rate, thus reducing
interest-sensitive private spending, especially
investment.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-16
Managing Public Debt: 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.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-17
Managing Public Debt: Various
Philosophies (cont.)
• 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).
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-18
Public Debt
• The total accumulation of the Federal Government’s
total deficits and surpluses over time.
Myths about public debt:
• Government is going bankrupt.
– Government can refinance existing debt.
– Government can create more money.
• Shifting burdens, future generations will pay for it.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-19
Problems with Public Debt
Economic implications:
• External debt may be a problem.
• Increased taxes may dampen incentives.
• Income distribution affected.
– Government bonds are generally held by those wealthier
members of society.
• Composition important: capital versus consumer
goods.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-20
Problems with Public Debt (cont.)
Crowding-out and 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.
• Two qualifications
– public investment
– unemployment.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-21
Public Debt: Positive Role
• Debt creation transfers saving to spenders and
thereby may play a positive function in maintaining a
high level of output and employment.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-22
Inflation and Fiscal Policy
• Some portion of the potential effect of an
expansionary fiscal policy on real output and
employment may be dissipated in the form of
inflation.
• The effect of fiscal policy on inflation affects net
exports through the foreign purchases effect.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-23
No Crowding-Out Effect
ASLS
AS
Price level
AD1
P3
P2
P1
AD2
Q1
Q2
AD3
Qp
Real gross domestic product
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-24
Crowding-Out Effect
AS
Price level
ASLS
AD1
P3
P2
P1
AD2
Q1
AD3
Q2 Qp
Real gross domestic product
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-25
Fiscal Policy and the Open
Economy
• The effectiveness of fiscal policy can be altered by
international conditions:
– shocks from abroad:
 Small economies are susceptible to international shocks that
can alter our GDP and render our fiscal policies inappropriate.
– net export effect.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-26
Net Export Effect
• The impact of interest rate-induced change in the
exchange rate, and thus net exports, following
changes in fiscal policy.
– Expansionary fiscal policy results in higher interest rates,
resulting in increased demand for $A, resulting in
appreciation of $A, resulting in a decline in net exports.
– Contractionary fiscal policy results in lower interest rates,
resulting in decreased demand for $A, resulting in
depreciation of $A resulting in an increase in net exports.
• Reduces the overall impact of fiscal policy
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-27
Fiscal Policy and Aggregate
Supply
• Fiscal policy, especially tax changes, affects not only
aggregate demand but can affect aggregate supply.
• Tax changes in the form of incentives to businesses
and individuals can lead to a rightward shift in the AS,
providing a further stimulus to the economy in terms
of lower prices and higher GDP.
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-28
Supply-Side Effect of Fiscal Policy
Price level
AD1
P3
ASLS
AS1
AS2
P2
=
P1
AD2
Q1 Q2 Q3 Qp
Real gross domestic product
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-29
Next Chapter:
Monetary policy and the
financial system
Copyright  2007 McGraw-Hill Australia Pty Ltd
PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada
By Muni Perumal
10-30