Week6

FiscalPolicy

Lectures11&12

Reference:Bernanke,OlekalnsandFrankChapter6

Doesitmatterinarecession:

whetherthegovernmentsendsyouachequeorgivesyoua
taxcut,or

whetheritpayssomeonetocomearoundandputnew
insulationintheroofofyourhouse?


FiscalPolicy

Doesitmatterinarecession:

whetherthegovernmentsendsyouachequeorgivesyoua
taxcut,or

whetheritpayssomeonetocomearoundandputnew
insulationintheroofofyourhouse?

QuestionaboutFiscalMultipliersandtheirmagnitude

InstrumentsofFiscalPolicy

G
Governmentexpenditure:currentgoodsandservices,
investmentandinfrastructure

T
Taxes(direct,indirect)incometaxes,consumptiontaxes
(GST)

Transferpaymentsunemploymentbenefits,pensions

IncomeExpenditure(KeynesianModel)

GovernmentdecisionsaboutGandTcanaffectthelevelof
outputintheeconomy

IncomeExpenditureorKeynesianModel

GovernmentdecisionsaboutGandTcanaffectthelevelof
outputintheeconomy

WeknowhowfromWeek5:

4sectormodel
1
Y
[C cT I P G X ]

[1 c(1 t )]
e

IncomeExpenditureorKeynesianModel

GovernmentdecisionsaboutGandTcanaffectthelevelof
outputintheeconomy

WeknowhowfromWeek5

4sectormodel
1
Y
[C cT I P G X ]

[1 c(1 t )]
e

Taxes

GovernmentSpending

IncomeExpenditureorKeynesianModel

GovernmentdecisionsaboutGandTcanaffectthelevelof
outputintheeconomy

WeknowhowfromWeek5

4sectormodel
1
Y
[C cT I P G X ]

[1 c(1 t )]
e

Taxes

GovernmentSpending

FiscalMultipliersin4SectorModel

WehavederivedequilibriumGDPas;

Ye

[C cT I P G X ]
[1 c(1 t )]

FiscalMultipliersin4SectorModel

WehavederivedequilibriumGDPas;

Ye

[C cT I P G X ]
[1 c(1 t )]

ChangeinG:

Y e
1

G [1 c(1 t )]

G>0impliesY>0

FiscalMultipliersin4SectorModel

WehavederivedequilibriumGDPas;

Ye

[C cT I P G X ]
[1 c(1 t )]

ChangeinG:

Y e
1

G [1 c(1 t )]

G>0impliesY>0

Y e
c

T [1 c(1 t )]

T>0impliesY<0

Changein T :

10

WhichhastheLargerEffectonGDP?

ExogenousTaxCutor
IncreaseinGovernmentSpending

EqualsizechangesinGandT

IncreaseGby100andcutTby100

11

WhichhastheLargerEffectonGDP?

ExogenousTaxCutor
IncreaseinGovernmentSpending

EqualsizechangesinGandT

IncreaseGby100andcutTby100

Example

PicksomenumbersforMPCandmarginaltaxrate

Letc=0.6andt=0.3

12

WhichhastheLargerEffectonGDPanExogenousTaxCutoran
IncreaseinGovernmentSpending?

c=0.6andt=0.3

IncreaseinG:
Y e

1
1
G
G 1.72 G

[1 0.6(1 0.3)]
0.58

13

WhichhastheLargerEffectonGDPanExogenousTaxCutoran
IncreaseinGovernmentSpending?

c=0.6andt=0.3

IncreaseinG:
Y e

Cutin T :
Y e

1
1
G
G 1.72 G

[1 0.6(1 0.3)]
0.58

0.6
0.6
(T )
T 1.03 T

[1 0.6(1 0.3)]
0.58

Governmentspendingmultiplierislarger(1.72vs.1.03)

14

WhyisGovernmentSpendingMultiplierlargerthanTax/Transfer
Multiplier?

Governmentpurchasesofgoodsandservicesareacomponentof
PAE

PAE C d I P G X

HaveadirecteffectonPAEandconsequentlyonY

15

WhyisGovernmentSpendingMultiplierlargerthanTax/Transfer
Multiplier?

Taxesandtransferpaymentsaffectthelevelofdisposableincome
(YT)receivedbytheprivatesector.

Exogenouschangesintaxesandtransfersonlyhaveanindirect
effectonPAE

PAE [C cT I P G X ] c(1 t )Y

WeightedbytheMarginalPropensitytoConsume(c)

16

WhyisGovernmentSpendingMultiplierlargerthanTax/Transfer
Multiplier?

Taxesandtransferpaymentsaffectthelevelofdisposableincome
(YT)receivedbytheprivatesector.

Exogenouschangesintaxesandtransfersonlyhaveanindirect
effectonPAE

PAE [C cT I P G X ] c(1 t )Y

WeightedbytheMarginalPropensitytoConsume(c)

Whathappensifcissmall?

17

BalancedBudgetMultiplier

Definition:

BudgetSurplus(Deficit)=TG

Supposeagovernmentwantedtoundertakeafiscalpolicythat
affectedthelevelofGDP,butdidntchangetheinitialvalueofthe
budgetdeficit.

Isthisevenpossible?

18

BalancedBudgetMultiplier

ConsiderequalchangesinGandTsothat(initial)levelofbudget
surplusisunchanged.

Increasegovernmentspendingby100(andsimultaneously)

Increaseexogenoustaxesby100

(Initial)BS=TG

BS=(T+100)(G+100)

Nochangeoninitialvalue

19

BalancedBudgetMultiplier

BeginwithequilibriumYin4sectormodel

Ye

1
[C cT I P G X ]

[1 c(1 t )]

Nowwritethisintermsofchanges

Y e

But

1
[C cT I P G X ]

[1 c(1 t )]

C I P X 0

20

BalancedBudgetMultiplier

Y e

Butwecanset

1
[cT G]

[1 c(1 t )]

(Why?)

Y e

1 c
G

[1 c(1 t )]

EventhoughwematchedtheincreaseinGwithanequalincrease
inT,theoveralleffectistoincreaseY.

21

BalancedBudgetMultiplier(BBM)

Letc=0.6andt=0.3

Y e

1 0.6
G 0.69 G

[1 0.6(1 0.3)]

Y e
0.69
G

BBM

Inthe4sectormodel,BBMispositivebutlessthanoneinvalue.

22

HowlargeareFiscalMultipliersinPractice?

InternationalMonetaryFund(IMF),2014,ReviewPaper

34empiricalstudiessince2000

GovernmentSpendingMultipliers
PlausibleRange:0.5to0.9

Tax/TransferMultipliers
PlausibleRange:0.1to0.3

EstimatestendtosmallerthanwhatisimpliedbyourIncome
ExpenditureModel

23

FiscalPolicyandOutputGaps

ModelimpliesthatchangesinGandTcanbeusedtocloseoutput
gaps,i.e.toensure Y Y *

2examplesusingour45odiagram

24

IncreasingGtoEliminateaNegative(Contractionary)OutputGap

PotentialOutput
PAE 45degreeline

Y * Y

25

IncreasingGtoEliminateaNegative(Contractionary)OutputGap

PotentialOutput
PAE 45degreeline

PAE1

Y e Y * Y
Outputgap<0

26

IncreasingGtoEliminateaNegative(Contractionary)OutputGap

PotentialOutput
PAE 45degreeline
PAEnew

PAE1

Y e Y * Y
Outputgap<0

27

IncreasingtheTaxRatettoEliminateaPositive(Expansionary)
OutputGap

PAE [C cT I P G X ] c(1 t )Y

TheslopeofthePAEcurveisgivenbyc(1t)anddependsont.
Whatistheeffectofanincreaseint?

28

IncreasingtheTaxRatettoEliminateaPositive(Expansionary)
OutputGap

PAE [C cT I P G X ] c(1 t )Y

TheslopeofthePAEcurveisgivenbyc(1t)anddependsont.
Whatistheeffectofanincreaseint?

Letc=0.6if
t=0.3slopeofPAE=0.6(10.3)=0.42
t=0.4slopeofPAE=0.6(10.4)=0.36

LargertgivesrisetoaflatterPAE

29

IncreasingtheTaxRatetoEliminateaPositive(expansionary)
OutputGap
PotentialOutput
PAE 45degreeline
PAE1

Y * Y e Y
Outputgap>0

30

IncreasingtheTaxRatetoEliminateaPositive(expansionary)
OutputGap
PotentialOutput
PAE 45degreeline
PAE1
PAEnew

Y * Y e Y
Outputgap>0
31

TheRoleofFiscalPolicyinStabilisingtheEconomy

Effectsoffiscalpolicyoccurin2ways:

Automaticstabilisers
tendencyforasystemoftaxesandtransferswhicharerelated
tothelevelofincometoautomaticallyreducethesizeofGDP
fluctuations

32

TheRoleofFiscalPolicyinStabilisingtheEconomy

Effectsoffiscalpolicyoccurin2ways:

Automaticstabilisers
tendencyforasystemoftaxesandtransferswhicharerelated
tothelevelofincometoautomaticallyreducethesizeofGDP
fluctuations

Discretionaryfiscalpolicy
referstodeliberatechangesinthelevelofgovernment
spending,transferpaymentsorintaxratese.g.oneoff
paymentsofupto$900,socalledcashsplash

33

AutomaticStabilisers

Systemoftaxesandtransferpaymentsthatactasautomatic
stabilisersfortheeconomy

AsGDPdeclines,theleveloftaxespaidfallsandthelevelof
transferpaymentsmadeincrease.

T T ( GDP ) impliesdeclineinbudgetsurplus

Thishappensautomatically(withoutanygovernmentaction)
andmakescontractionsandexpansionsinGDPsmallerthan
theywouldhavebeenotherwise.

34

ImpactofAutomaticStabilisers

GDP

ImpactofAutomatic
Stabilisers

Time

35

DiscretionaryFiscalPolicy

PriortocurrentGlobalFinancialCrisis(GFC),theimportanceof
fiscalpolicyasa(discretionary)policyinstrumentforstabilizing
theeconomyhadbeendeclining.

Quotefrom3rdeditionofBOF(page186)

Fiscalpolicyisnotoftenusedasastabilisationtool

36

PerceivedLimitationswithDiscretionaryFiscalPolicy

Policylags

Tobeusefulasastabilizationtool,discretionarychangesin
fiscalpolicyneedtobeimplementedinatimelymanner(i.e.
nopointinincreasinggovernmentspendingjustwhenthe
recessionisoverandeconomyisinanexpansion).

Inpracticechanginggovernmentspendingortaxestypically
involvesalengthylegislativeprocess(inAustraliatheBudget
needstobepassedbyboththeHouseofRepresentativesand
theSenate)

37

 Mostchangesinfiscalpolicyareonlymadeonanannualbasis
inaGovernmentsBudget(inAustraliaFederalBudgetis
broughtdowninMay)

Ideally,macroeconomicpolicyshouldbeforwardlooking,e.g.
fiscalpolicychangesmadetodayshouldbedesignedto
influencefuture(forecast)levelsofoutput

38

WhatwasdifferentaboutGFC?

FallsinGDPwereprecededbyafinancial/creditcrisis
(providedadvancedwarningforgovernments)

Manycountries(notAustralia)havehadrelativelylargeand
persistentfallsinGDP

Concernsabouttheabilityofmonetarypolicytoprovide
sufficientstimulustoeconomies

Providedgreaterscopeforgovernmentstousefiscalpolicyina
timelymanner

39

Structuralvs.CyclicalChangesinBudget

Discretionaryfiscalpolicycanbeequatedwithstructuralchanges
inthebudget

Automaticstabilisersdrivecyclicalchangesinbudget

InresponsetotheGFC:
observeacyclicaldeclineinthebudgetbalance(mostlydue
todeclineinT)asautomaticstabiliserswork,and

astructuraldeclineduetobigdiscretionaryincreasesinG
andreductionsin

40

AutomaticStabilisers(Cyclical)andDiscretionary(Structural)
ComponentsofChangeinFiscalBalance
3

%GDP

%GDP

Contractionary

3
2

-1

Structural balance

-1

-2

Cyclical balance

-2

-3

Total balance

-3

Expansionary

-4

-4

-5

-5
01/02

03/04

05/06

07/08

09/10

11/12

41

SupplySideEffectsofFiscalPolicy

Fiscalpolicycanhavelongrunaffects(onpotentialoutputY*)as
wellasitsshortruneffectson(YY*)

Governmentinvestmentspendingoninfrastructuresuchasroads,
airportsandschoolscanplayamajorroleinthegrowthof
potentialGDP.

Ideallysuchinvestmentsshouldprovideasatisfactoryeconomic
rateofreturn.

Avoidwhiteelephantsoruneconomicinvestments

42

BreakupofAustralianFiscalStimulusResponsetoGFC(Feb2009)

$42billionNationBuildingandJobsPlan

$29billionforinvestment:

$12.7billionincurrentspending

About70percentoffiscalpackagecouldbeclassifiedas
investment.

Mighthavesupplysideorproductivityenhancingeffects;in
additiontostandardmultipliereffectspredictedbytheKeynesian
model

43

IncentiveEffectsofTaxesandTransfers

Taxesandtransferpaymentsplayaroleinaffectingincentives
andeconomicbehaviour

Taxesonlabour
incomerateratesandstructureofgovernmentpaymentscan
influencelaboursupplydecisions

Taxesoncapital
companytaxratescaninfluenceafirmsinvestmentdecisions
andaffectthelevelofprivatecapital

44

LabourMarket

real
wage

(W/P)*

Ls

Ld

L*

45

EffectofanIncomeTax

real
wage

Reduceslaboursupply

Ls(withtax)

Ls

Ld

L*

46

FiscalPolicyandPublicDebt

BudgetSurplus(Deficit)=TG

Budgetsurplus/deficitisaflowvariable

Budgetdeficitsneedtobefinancedinsomemanner

Astandardsourceoffinancingistoborrowfromtheprivate
sector.

47

PublicDebt

Theoutstandingstockofgovernmentborrowingiscalledpublic
debt.

Publicdebtequalsthesumofallpastdeficitslessanysurpluses.

48

BudgetBalanceandNetGovernmentDebtforAustralia

%ofGDP

0
201415

201314

201213

201112

201011

200910

200809

200708

200607

200506

6
Budgetbalance

Netdebt

49

BudgetDeficitsand(Gross)PublicDebt(%GDP)
2007 2009 2010 2014
Australia
Deficit 1.5 4.3 5.3 1.1
Debt 9.8 16.9 22.7 27.8

US
Deficit 2.8 12.5 10.0 6.7
Debt 61.9 84.8 93.6 108.2

Japan
Deficit 2.5 10.5 10.2 8
Debt 187.8 218.6 227 245.6

50

GovernmentBudgetConstraint

Agovernmentcanfunditsoutlaysin3ways:
Taxes
Borrowing(i.e.itcansellagovernmentsecurity)
PrintingMoney

Lastapproachhasbadreputationassociatedwithhyperinflation
(monthlyinflationgreaterthan50%)

51

GovernmentBudgetConstraint

Meansofrelatinggovernmentoutlays(purchasesandtransfer
payments)totheirmethodoffinancingisviathegovernment
budgetconstraint.

52

GovernmentBudgetConstraint:Notation

Gt =governmentpurchases
Qt =transferpayments

~
Tt =taxes
Bt 1 =stockofgovernmentsecurities(i.e.publicdebt)at

theendofperiod(t1)(orbeginningofperiodt)
rBt 1 realinterestpaymentsonpublicdebt

Note:Theabovenotationseparatestaxesandtransferpayments.
Intermofourpreviousnotation
~
Tt Tt Qt .

53

GovernmentBudgetConstraint

Governmentexpenditures(purchases,transferpaymentsand
interestpayments)inanyperiodneedtobefundedbytaxesorby
borrowing.

Assumegovernmentdoesnotusemoneyfinance

~
Gt Qt rBt 1 Tt Bt Bt 1

useoffunds=sourceoffunds

54

GovernmentBudgetConstraint

~
Gt Qt rBt 1 Tt Bt Bt 1

Rearranging

~
Gt Qt rBt 1 Tt Bt Bt 1

WhentheGovtrunsadeficitbudget,thelefthandsideispositive,
andwewillbeaddingtothestockofpublicdebt.(Publicdebtwill
fallwithabudgetsurplus).

55

GovernmentBudgetConstraintandInflation/Hyperinflation

~
Gt Qt rBt 1 Tt Bt Bt 1

Supposethatgovernmentcannotborrow(anymore)

Bt Bt 1 0

Thenif

~
Gt Qt rBt 1 Tt

Onlyothersourceoffundsisthecentralbank,andtheseare
providedintheformofnewcurrency(printingmoney).
56

PrintingMoney

Supposethatthegovernmentisunabletoraisesufficientrevenue
tocoveritsexpenditureandrunsabudgetdeficit

(Inadditionitfinds)itcannotborrowenoughfrompublicorfrom
abroadtofinanceitsdeficit

Onlyothersourceoffundsisthecentralbank,andtheseare
providedintheformofnewcurrency(printingmoney)

Zimbabweprovidesarecentexampleoftheproblemand
Germanyanearlierone.

57

HyperinflationinGermany1920s
LogofGermanPriceLevel
14

12

LogofPriceLevel

10

0
1914July

1919Jan

1919July

1920Jan

1921Jan

1921July

1922Jan

1922July

1923Jan

1923July

1923Nov

58

300
InflationRate

GermanInflationRate
700

600

500

400

200

100

1919Jan

1919July

1920Jan

1921Jan

1921July

1922Jan

1922July

1923Jan

1923July

1923Nov

100

59

CostsofPublicDebt

CrowdingOut:Highlevelsofgovernmentborrowingmayraise
realinterestratesandthiswilltendtocrowdoutprivate
investmentandcapitalformation(seeS&ImodelfromWeek2).

S(r)
realinterestrate
S(r)

I(r)

I,S

60

CostsofPublicDebt

IntergenerationalEquity:Borrowingbecauseofdeficitbudgets
cantbesustainedforever,andeventuallysurpluseswouldbe
requiredtoreducedebt.

Intergenerationalequitymeansweshouldnotenjoythebenefits
ofbudgetdeficitsnowandpassonthecostsofthosedeficitsto
futuregenerations.

61

BenefitsofPublicDebt

Oneuseofpublicdebtistofinancetheprovisionofpublic
infrastructure.Whereinfrastructurehasthecharacteristicsofa
publicgooditwillbeundersuppliedbytheprivatesector.

Someestimatessuggestthatthereturnstoinvestmentin
infrastructurearerelativelyhigh.

Thusitispossiblethatpublicdebtmayhaveanetbenefitforthe
economy,evenwhenallowingforcrowdingoutand
intergenerationalequityeffects.

62

FiscalPolicyChallengesDemographicChange

ExpectedincreaseAustraliaspopulation(updated):
2010 2050
22.2mill 36mill

Decliningfertilityratesandincreasedlongevitymeansthatpeople
65andoverarelikelytogofrom14%ofthepopulationto23%in
thattime.

ThishasimplicationsforGovernmentexpenditure,ashealth,aged
careandpensionspendingwillincreaseoverthattime.

63

AustraliasPopulationisProjectedtoAge,DespiteImmigration
75
60

Age 50

% share
1971

ABSCat3222.0
September2008 B
projections

40

2006
2021

45

30

2051
Median age 1971;2006;2021;2051

30

20

15

10

0
0-14

15-64

65-84

85+

64

65

WhataboutFutureTaxRevenues?

Difficulttoforecast.Dependson;
Taxrates
Sizeoflabourforce
GrowthrateofGDP

SupposeweassumethatGovernmentrevenueasaproportion
ofGDPwillremainatabout22%.

Projectionthenseeslargedeficitsfromabout2025onwards.

66

67

Whattodo?

2009budgetincreasedpensionagefrom65to67
However,pensionageisnotretirementage
Canaccesssuperannuationat55or60(someincentives
forwaittill60)andretire
Currentaverageretirementageislessthan60

Othermeasurestoincreaseactualretirementage
allowageatwhichonecanaccesssupertoriseto67?

Startworkingearlier?

ORIncreasetaxes

68