WHAT IS THE ROLE OF FISCAL POLICY IN THE ECONOMY?

What is Fiscal Policy?

Fiscal Policy is the use of changes in the level and direction of government spending (G) and revenue (T) to influence income distribution, resource allocation and the level of economic activity.
The main instrument of Fiscal Policy is the Commonwealth Government Budget. It is an announcement of the planned levels of G and T for the financial year. The Budget Papers set out the government expenditure (G) as Expenses and government receipts (T) as Revenue.

What is Fiscal Policy?

There are 3 possible budget outcomes.

They are:

a Deficit Budget, G > T a Surplus Budget, T > G

a Balanced Budget, G = T

Australian Government Budgets

Australian Governments over much of the last 30 years have run Budget Deficits. This has often been done in an attempt to reduce the level of unemployment or as a result of the level of unemployment, in Australia.

2007-08

Budget Deficits and Public Debt

The effect of these regular budget deficits was an increase in the Public Debt in money terms and increased pressure on the Foreign Debt in the period up to 1995.

Commonwealth General Government Net Debt and Net Interest Outlays to GDP
Since then public debt has been on decline due to budget surpluses and in 2006 was fully paid off. The Global Financial Crisis that began in 2008 turned the Australian Budget back into a deficit due to falling tax revenue, increased spending on welfare and a stimulus package to create growth in the economy.

HOW DOES THE BUDGET AFFECT THE ECONOMY?

The Governments Fiscal Stance refers to whether it is trying to increase growth (expansionary policy) or slow the rate of growth in the economy (contractionary policy).
This is not simply a matter of having a budget deficit or surplus. When the economy is growing this automatically reduces G and increases T (less spending on welfare and more tax revenue, due to lower unemployment levels).

HOW DOES THE BUDGET AFFECT THE ECONOMY?

The Budget has a number of effects on the economy.

Initially changes in G will affect the level of aggregate expenditure and aggregate demand and thus income in the economy. The income change will be magnified by the multiplier effect.

Any increase in income generates increased employment and economic growth, while reductions in income do the opposite.

What effect will increased Government Expenditure have?

A rise in G will shift the aggregate expenditure curve upwards by the size of the increase, eg a rise in G of 200 will increase equilibrium income in the economy from 400 to 800. In this case the multiplier is 2.

1400 1200 1000

AE +G AE

E X P

800 600 400 200 0 0

45
400 800 1200

HOW DOES THE BUDGET AFFECT THE ECONOMY?

There are also second round or reactionary effects that occur. For example an increase in G without a corresponding increase in T, ie. G > T, will increase demand and increase income initially, by the multiplier effect. However, this increase in income will increase demand for money. If the government finances the budget deficit by borrowing, this will also increase the demand for money.

HOW DOES THE BUDGET AFFECT THE ECONOMY?

An increase in the demand for money will shift the demand curve to the right and increase interest rates. The rise in interest rates will discourage investment r > MEC. This will reduce I leading to a fall in Aggregate

30 25 20

r 15
10 5 0 0 5

s d2 d1
10 15 20

Quantity of money

HOW DOES THE BUDGET AFFECT THE ECONOMY?

So the overall effect of a larger budget deficit due to increased G will be an initial large increase in Aggregate Expenditure, Exp AE1, followed by a small decline in Aggregate Expenditure from AE1 to AE2. Income initially rises to an equilibrium at 800. It then moves back to 700 as a result of the rise in

1400 1200 1000 800 600 400 200 0

AE1 AE2 AE

45
0 400 800 1200

HOW DOES THE BUDGET AFFECT THE ECONOMY?

Similarly a cut in the size of the budget deficit or an increase in the budget surplus will shift the aggregate expenditure line down from AE to AE1. This will reduce national income and lead to increased levels of unemployment.

1400 1200 1000

AE

Exp 800
600 400 200 0 0 400 800

AE1

1200

HOW DOES THE BUDGET AFFECT THE ECONOMY?

The fall in income and the reduced need for the 1400 government to sell bonds to 1200 finance the budget deficit 1000 will reduce interest rates Exp 800 which will encourage I. This will lead to a secondary 600 increase in aggregate 400 expenditure, from AE1 to 200 AE2, which will increase income and employment. 0 0 The overall effect will be a decline in income from 800 to 500.

AE AE2 AE1

400

800

1200

How do changes in taxation affect the level of income?

A decrease in the marginal rate of tax (MRT) will increase the angle of the aggregate expenditure line from AE0 to AE1. This will increase the equilibrium income level from $500 billion to $800 billion. Similarly an increase in the MRT will decrease the angle of the aggregate expenditure

1400 1200 1000 800

AE1 AE0

E x p

600 400 200 0 0 400 800

1200

FINANCING THE BUDGET DEFICIT

A budget deficit occurs when G > T. There is a shortage of funds to pay for the government spending. The budget has to be financed. There are three possible ways this can be done. They are:Monetary Financing:- This involves the Treasury borrowing from the Reserve Bank. The Reserve Bank prints more money. This is inflationary.

FINANCING THE BUDGET DEFICIT

Borrowing from the Australian Public:- This involves the Treasury selling treasury notes and government bonds to Australian citizens and institutions. This increases the demand for money and pushes up interest rates. Borrowing from Overseas:- This will increase the Foreign Debt.

WHAT IS THE GOVERNMENT CURRENTLY DOING?

The Australian Government has aimed to achieve a positive Fiscal Balance. In the period 1994 to 2008 they reduced the budget deficit steadily and moved into a surplus. Most of the achievement of positive fiscal balances (surpluses) have come about through
Economic growth in the economy reducing unemployment and as a result reducing welfare spending and increasing tax revenue, cuts to government spending, increased fees and charges and allowing wage rises to increase income tax revenue (Fiscal Drag)

What is the Governments Fiscal Strategy?

When asset sales are included, eg Telstra, Commonwealth Bank, Sydney Airport, there has been a headline cash surplus in most years since the second half of the 1990s. The Governments basic plan is to cut government spending and to achieve balanced or surplus budgets over the life of the business cycle .
This will increase the Government Finance Statistics Net Lending and thus reduce the need to borrow funds from overseas.

WHAT IS THE GOVERNMENT TRYING TO ACHIEVE?

This should reduce domestic interest rates and as a result increase investment in Australia. This will also act to reduce aggregate demand and thus keep inflation low. The lower levels of demand should also reduce imports and improve the current account. Until 2008 the Government did not consider unemployment to be a high priority. They believe that investment and business growth will bring a reduction in unemployment.

THE GFC and the Budget

In the second half of 2008 the Global Financial Crisis developed and governments around the world were faced with deficit budgets. Taxation revenue declined due to lower incomes.

Welfare payments rose due to increased unemployment.

Governments increased government expenditure to stimulate the economy and to increase economic growth.

October 2008 Stimulus Package

In light of the global economic financial crisis the Australian Government decided in October 2008 to release a $10.4 Billion Stimulus Package to the economy. The main areas of spending were for the lowest income recipients eg pensioners. This is the group that could most be disadvantaged by the crisis but will also be most likely to spend the money and as a result have greatest impact on the economy. The Government also increased the first home buyers rebate to stimulate the housing industry.

October 2008 Stimulus Package

The impact of the fiscal stimulus package was to: Pump prime the economy to increase aggregate expenditure and increase economic growth Boost the housing industry and associated industries. It could have added to inflation and put pressure on interest rates if the global slowdown was only short lived.

The 2011-12 Budget

The 2012-13 underlying cash balance has been reduced from a deficit of $ 44.4 billion (-3% of GDP) in 2011-12 to a $1.5 billion surplus (0.1% of GDP)

What impact will the budget deficit have on the economy?

The Budget Deficit will initially increase Aggregate expenditure, aggregate demand and income in the economy.
This can reduce the impact that the Global recession will have on GDP and unemployment (at least temporarily). Although the RBA has employed contractionary M.P. an increase in G could increase domestic interest rates and as a result decrease investment in Australia. An increase in G increases aggregate demand and could therefore add to inflation.

What impact will the budget deficit have on the economy?

Higher levels of demand could increase imports (i.e. capital) and therefore add further to inflation.
The Budget will increase the level of Public Debt The government will most likely need to call on overseas funds which will add pressure to the CAD.

This could increase Foreign Debt as a % of GDP.

The Budget will have no surplus funds to provide for the future i.e. areas such as Australias aging population.

What is the relationship between the Commonwealth Budget and CAD?

Fiscal Policy is the main macroeconomic policy instrument, at this time, due to the Governments emphasis on the TWIN DEFICIT THEORY. This implies that a reduction in the Budget Deficit (PSBR) will lead to a reduction in the Current Account Deficit. I+G+X=S+T+M I + (G - T) = S + (M - X) I + PSBR = S + CAD If S = I, then a reduction in the Public Sector Borrowing Requirement (PSBR) will reduce the CAD.

What can be done to reduce STAGFLATION?

Fiscal Policy is very limited in its ability to reduce inflation and unemployment at the same time. Generally stagflation is caused by increased costs. So any policies that may reduce costs will be of some use eg. cut income tax cut company tax cut indirect taxes