Chapter 9

Fiscal Policy and the

Public Debt
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PPTs t/a Macroeconomics 7/e by Jackson and
McIver
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9-1

Learning Objectives
Briefly outline the nature of federal

government expenditures and

revenues.
Explain how a degree of economic
stability
is McGraw-Hill
built intoAustralia
our tax
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2004
Pty Ltd
system.
PPTs t/a Macroeconomics 7/e by Jackson and
Survey some basic problems in the
McIver
application
of Perumal,
fiscal University
policy. of
Slides
prepared by Muni
Canberra, Australia
9-2

Learning Objectives (cont.)

Briefly discuss several contrasting

budget philosophies.
Assess the quantitative and qualitative

aspects of the public debt.

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2004
Australia
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Discuss
theMcGraw-Hill
implications
of and

complications associated with fiscal

PPTs t/a Macroeconomics 7/e by Jackson and
policy within the aggregate demand
McIver
aggregate
supply
framework
Slides
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Perumal,
University of
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9-3

Federal Government
Finance
Federal expenditures

large expenditure on social security and welfare

specific purpose grants

Federal revenues

Personal income tax

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2004 McGraw-Hill Australia Pty Ltd

Company income tax

Indirect and other taxes

PPTs t/a Macroeconomics 7/e by Jackson and

sales tax
McIver
excise tax
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9-4

Discretionary Fiscal Policy

The deliberate manipulation of

taxes and spending by

government for the purpose of
altering real GDP and
Copyright 2004 McGraw-Hill Australia Pty Ltd
employment, controlling inflation
and
stimulating
economic
PPTs
t/a Macroeconomics
7/e by
Jackson and growth
McIver
Not
all fiscal
is deliberate
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by Muni policy
Perumal, University
of
Canberra, Australia
9-5

Expansionary Fiscal Policy

If budget is initially balanced,

moves it towards a budget deficit

during recession
Increased government spending
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and/or lower taxes

PPTs t/a Macroeconomics 7/e by Jackson and

McIver
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Canberra, Australia
9-6

Contractionary Fiscal
Policy
If budget is initially balanced,

moves it towards a budget

surplus during an inflationary
period

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Decreased government spending

PPTs
t/a Macroeconomics
by Jackson and
and/or
higher 7/e
taxes
McIver
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Canberra, Australia
9-7

Financing
Deficits fiscal policy
Effect of expansionary
depends on method by which the
deficit is financed
Borrowing: May increase interest rates, thus
crowding
some investment
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2004out
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Money creation:
PPTs t/a Macroeconomics
7/ethe
by RBA
Jackson
and new
Deficit financed by
by issuing
McIver money
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Muni Perumal,
University
of
Avoidsby
crowding
out private
spending
Canberra, Australia

9-8

Disposing of Surpluses
Effect of contractionary fiscal

policy depends on method by

which the surplus (or movement
towards surplus) is financed
Debt reduction: May reduce anti-inflationary
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2004 McGraw-Hill Australia Pty Ltd
impact of policy by reducing interest rates,
thereby stimulating private spending
PPTs t/a Macroeconomics 7/e by Jackson and
Idle surplus (or impounding): Government
McIver
power
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Muni Perumal,
University of

Canberra, Australia
9-9

Non-Discretionary Fiscal
Policy
Built-in stabilisers that operate without

requiring explicit action by policymakers

During recessions: Tend to increase

government
deficits (or
reduce
surplus)
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2004 McGraw-Hill
Australia
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During inflationary periods: Tend to
PPTs t/a Macroeconomics 7/e by Jackson and
increase government surpluses (or
McIver
reduce
deficits)
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910

Automatic or Built-in
Stabilisers
Tax receipts: Increase as real GDP

increases
Transfers: Decrease as real GDP
increases
Do not correct; only reduce the
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2004
McGraw-Hill Australia Pty Ltd
severity
of fluctuations
Useful when economy is operating
PPTs t/a Macroeconomics 7/e by Jackson and
around full employment
McIver
Can
cause
problems:
Fiscal Drag
Slides
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Perumal, University
of
Canberra, Australia
9-11

Government expenditure
and tax revenue

Built-in Stabilisers

Surplus
G

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

McIver
GDP3
GDP1
GDP2
Slides prepared by Muni Perumal, University of
Real GDP (billions)
Canberra, Australia

912

Fiscal Drag
Occurs when an economy

stabilises at an undesirable
output level because of the
operation of automatic stablisers

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Over time as an economy grows,

PPTs
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by Jackson
and
this
can choke7/eoff
growth
McIver
Cure:
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by Muni Perumal, University
Discretionary
fiscal of
policy
Canberra, Australia
913

A Governments Fiscal
Stance
Difficult to judge. Why?
Actual budget surpluses or deficits in

any given year do not necessarily

indicate the governments true fiscal
stance.
Why?
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2004
McGraw-Hill Australia Pty Ltd
Built-in stability
PPTs t/a Macroeconomics 7/e by Jackson and
Solution: Cyclically adjusted budget
McIver
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Canberra, Australia

914

Cyclically Adjusted Budget

Indicates what the budget deficit

(or surplus) would be if the

economy were to operate at
potential output throughout the
Copyright 2004 McGraw-Hill Australia Pty Ltd
year
PPTs t/a Macroeconomics 7/e by Jackson and
McIver
Slides prepared by Muni Perumal, University of
Canberra, Australia

915

Problems with Fiscal

Policy in Practice
Problems of timing

Recognition lags
Administrative lags
Operational lags

Political
problems
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2004
McGraw-Hill Australia Pty Ltd
Other economic goals: not just stability
PPTs t/a
Macroeconomics
7/e by Jackson and
Expansionary
bias
McIver
A political business cycle
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Canberra, Australia
916

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
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2004
McGraw-Hillespecially
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private
spending,
investment

PPTs t/a Macroeconomics 7/e by Jackson and

McIver
Slides prepared by Muni Perumal, University of
Canberra, Australia

917

Managing Public Debt:

Various Philosophies
Annually balanced budget

Pro-cyclical: intensifies recession or

inflation

Cyclically balanced budget

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2004 McGraw-Hill Australia Pty Ltd
Counter-cyclical
Not annually balanced
PPTs t/a Macroeconomics 7/e by Jackson and
Problem: upswings and downswings may
McIver
be of
magnitude
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Muni Perumal,
University of
Canberra, Australia
918

Managing Public Debt:

Various Philosophies

Functional finance
(cont.)

Primary purpose is to balance the

economy, not the budget

The problems of continuing annual deficits

Copyright 2004 McGraw-Hill Australia Pty Ltd
(or surpluses) may be small compared to
the
alternative: 7/e
recession
and
PPTs t/a
Macroeconomics
by Jackson
andhigh
McIverunemployment (inflation)
Slides prepared by Muni Perumal, University of
Canberra, Australia
919

Public Debt
The total accumulation of the Federal

Governments total deficits and

surpluses over time
Myths about public debt:
Government is going bankrupt

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2004 McGraw-Hill
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Government
can refinanceAustralia
existing debt

Can create more money

PPTs
t/a Macroeconomics
7/efuture
by Jackson
and
Shifting
burdens,
generations
McIver
will pay for it
Slides prepared by Muni Perumal, University of
Canberra, Australia
920

Problems with Public Debt

Economic implications
External debt may be a problem
Increased taxes may dampen incentives
Income distribution
Government
are generally
heldPty
by those
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2004bonds
McGraw-Hill
Australia
Ltd
wealthier members of society

PPTs
t/a Macroeconomics
7/e by Jackson
and versus
Composition
important:
capital
McIver
consumer goods
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Canberra, Australia
921

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
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reduces investment spending
Two
qualifications
PPTs
t/a Macroeconomics
7/e by Jackson and
Public investment
McIver
Unemployment
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Canberra, Australia

922

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
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employment
PPTs t/a Macroeconomics 7/e by Jackson and
McIver
Slides prepared by Muni Perumal, University of
Canberra, Australia

923

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
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2004 of
McGraw-Hill
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The effect
fiscal policy

affects
net
exports
through
the
PPTs t/a Macroeconomics 7/e by Jackson and
foreign purchases effect
McIver
Slides prepared by Muni Perumal, University of
Canberra, Australia

924

No Crowding-Out Effect
ASLS

AS

Price level

AD1

P3
P2
P1

Copyright 2004 McGraw-Hill Australia Pty Ltd

AD2and AD3
PPTs t/a Macroeconomics 7/e by Jackson
McIver
Q1
Q2 Qp
Slides prepared
Muni Perumal,
University
Realbygross
domestic
productof
Canberra, Australia

925

Crowding-Out Effect AS
Price level

ASLS

AD1

P3
P2
P1

Copyright 2004 McGraw-Hill Australia Pty Ltd

AD3
AD
PPTs t/a Macroeconomics 7/e by Jackson2 and
McIver
Q1
Q2 Qp
Slides prepared by Muni
Perumal,
University of
Real gross domestic product
Canberra, Australia

926

Fiscal Policy and the Open

Economy
The effectiveness of fiscal policy

can be altered by international

conditions:
Shocks from abroad: small economies are
Copyright
2004 McGraw-Hill
Australia
Pty Ltdthat
susceptible
to international
shocks
can alter our GDP and render our fiscal
PPTs t/a
Macroeconomics
7/e by Jackson and
policies
inappropriate
McIver
Net export effect
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Canberra, Australia
927

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
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2004 McGraw-Hill
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Pty Ltd
interest rates resulting in increased
PPTs t/a
Macroeconomics
7/e by Jackson
and
demand
for $A resulting
in appreciation
of
McIver$A resulting in a decline in net exports
Slides prepared by Muni Perumal, University of
Canberra, Australia
928

Net Export Effect (cont.)

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

Copyright 2004 McGraw-Hill Australia Pty Ltd

fiscal policy

PPTs t/a Macroeconomics 7/e by Jackson and

McIver
Slides prepared by Muni Perumal, University of
Canberra, Australia

929

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
individuals
can
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2004 and
McGraw-Hill
Australia
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Ltd to a

rightward shift in the AS, providing a

PPTs
t/a Macroeconomics
7/e by
Jackson
and
further
stimulus to
the
economy
in
McIver
terms of lower prices and higher GDP
Slides prepared by Muni Perumal, University of
Canberra, Australia

930

Supply-Side Effect of Fiscal Policy

Price level

AD1

P3

ASLS

AS1

AS2

P2
P1

Copyright 2004 McGraw-Hill Australia Pty Ltd

=

ADand
PPTs t/a Macroeconomics 7/e by Jackson
2
McIver
Q1 Q2 Q3 Qp
Slides prepared by Muni Perumal, University of
Real gross domestic product
Canberra, Australia

931

Next Chapter:
Money, Banking and the
Financial System

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

932