Topic 11

Fiscal Policy
 Key Concepts
• Fiscal policy
• Discretionary fiscal policy
• Automatic stabilisers
• The federal budget
• The macroeconomic significance of
the budget
• Implications of the budget outcome
for government debt levels

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 Fiscal Policy
Fiscal Policy: Changes in federal government
spending taxes and that are intended to
achieve macroeconomic policy objectives,
such as full employment, price stability, and
sustainable rates of economic growth.

3
 The Federal Budget
• The Australian federal budget (May each
year) is the principal fiscal policy statement
each year.
• The budget outcome is usually described as
being:
– in surplus (government revenue exceeds
government spending); or
– in deficit (government spending exceeds
government revenue).

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 The Budget Outcome
• The budget outcome is of interest because:
– federal government outlays are a
considerable percentage of GDP
– the budget announces the government’s
fiscal stance (whether the government is
trying to expand or contract economic
activity).
– The Australian Government Budget
– The New Zealand Government Budget
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 Discretionary fiscal policy versus Automatic
stabilisers.
 Discretionary fiscal policy is used as a counter
cyclical tool. It is the deliberate changes in
government spending and/or taxation decisions
with the aim of achieving the government’s macro
policy objectives such as low inflation and full
employment.
 Automatic stabilisers: Government spending and
taxes that automatically increase or decrease along
with the business cycle.

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 Discretionary Fiscal Policy
• Discretionary fiscal policy is the use of changes in
government spending and/or taxes to alter
aggregate demand (AD) and stabilise the economy.
• The government can increase AD through
expansionary fiscal policy.
• The government can reduce AD through
contractionary fiscal policy.

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 Increasing Government Spending to
Combat Recession
• In a period of slow economic growth, policy makers
could either:
– do nothing and wait for the business cycle to
expand, or
– increase government spending and or decrease tax.
• This expansionary fiscal policy would:
– shift the AD curve outwards (to the right)
– increase real GDP
– raise the price level.
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 Expansionary Fiscal Policy
Aim: To combat or prevent a recession by providing an economic
stimulus and increases aggregate demand or real GDP
How: Increase Government Expenditure (G), Decrease Taxes or
Combination of both measures. Depending on the tax cuts,
investment and/or consumption will increase.
Will results in a budget deficit if budget was previously balanced. Or
it may result in a smaller surplus if budget was previously in surplus.
NOTE: A budget deficit financed out of borrowing can result in the
crowding out effect, which will decrease the impact of the
government’s expansionary fiscal policy
Increasing Government Spending
to Combat Recession

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 Expansionary FP and The Crowding Out Effect
If an expansionary FP results in a budget deficit that is financed by
government borrowing from the money market, the crowding out
effect can occur and reduce the impact of the expansionary FP.

What is the crowding out effect?

The crowding out effect is a decrease in private investment due to an
increase in government borrowings from the money market to finance
its budget deficit. When government borrows it increases the demand
for money which will increase interest rate. When interest rate
increases, the cost of borrowing rises and this can cause a crowding
out of private investment
Crowding out effect
G, increases MD to MD1: Int. rate from r to r1:
Investment from I to I1
Interest Interest
MS
Rate Rate

• •
b b
r1
r1

r • a
MD1
r
• a

MD Inv
Q Quantity I1 I Quantity
 Contractionary Fiscal Policy
• Aim: To slow economic growth in order to reduce
demand pull inflation or bring the budget back to surplus
• How: Decrease Government Expenditure
• Increase Taxes
• Combination of both measures
• Effect: Decreases GDP and reduces inflationary pressures
• Results in budget surplus if budget was balanced or a
lower deficit if budget was previously in deficit.
 Using Fiscal Policy to
Combat Inflation (Cont’d)

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Discretionary Fiscal Policy

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 Automatic Stabilisers
• Government revenues and expenditures
automatically change over the course of
the business cycle.
• These changes help to stabilise the
economy to some extent, without the
need for changing government spending
too much.

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 Automatic Stabilisers (Cont’d)
• Transfer payments (e.g. job search
allowance) fall as GDP rises, mainly
because unemployment falls.
• On the other hand, tax revenues and GDP
are directly related (higher personal and
business incomes, and therefore, higher
tax revenue).

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Automatic Stabilisers

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 Fiscal Policy: Problems
FP faces the following problems:
• Time Lags
• Political Problems
• Crowding out effect
• Slower to implement than MP
 Time lags
• Recognition lag: the time it takes policy
makers to ascertain there is a problem to be
addressed.
– Legislative lag: the time it takes to have
policy approved by both Houses of Federal
Parliament.
– Implementation lag: the time it takes to
implement the policy, and for the policy
to take effect.

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 Crowding Out
• Crowding out occurs when there is a reduction in
private sector spending due to federal budget
deficits being financed by government borrowing.
• In order to finance the deficit, the government
must compete for funds in the financial market
which increases interest rates.
• High rates discourage private sector spending (or
borrowing to invest).
• Crowding out will reduce the impact of
expansionary fiscal policy.
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Government expenditure as a percentage of GDP, 1960 - 2007

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Government Expenditure
Government expenditure by function, 2007/08

Source: Australian Government (2007), Budget 2007-08, Appendix D,

Australian government taxation and spending, viewed 5 May 2008, at
www.budget.gov.au. Copyright CGA, Reproduced by permission.

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Government revenue by source, 2007/08

Source: Australian Government (2007), Budget 2007-08, Appendix D,

Australian government taxation and spending, viewed 5 May 2008, at
www.budget.gov.au. Copyright CGA. Reproduced by permission.

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 The Countercyclical
Role of Fiscal Policy and the Budget
• The countercyclical role of fiscal policy implies
budget deficits in times when economic activity
is low (recession) and budget surpluses in times
when economic activity is high (boom).

Many governments now place an emphasis on their

budgets being ‘in balance’ over the course of the
business cycle in order to show that they are
responsible and are safe borrowers.

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 Other Roles of Fiscal Policy
• The budget also reflects medium-to-long-
term goals.
• Recent policy initiatives have included:
– the introduction of the GST in 2000, which
broadened the tax base
– greater focus on economic growth
– focus on reducing the unemployment rate.

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Implications of the Budget Outcome
for Government Debt
• Budget deficits add to government debt.
– This is the total value of outstanding
government securities.
• The Australian government debt to external
parties is relatively low in comparison to
OECD figures.
• Future budget deficits will need to be
financed by money or debt financing.
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General Government Net Debt Levels

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 The Burden of the Debt
• The burden of the debt is the possibility
that government debt could create a
burden on future generations.
• It should be remembered, however, that
much wealth creation involves the use of
borrowing and debt.
• Much government debt has also been
used to finance infrastructure.
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 The External Component of
National Debt
• The portion of a country’s national debt that
is owed to foreigners is a different matter.
• Currently Australia has a negligible
component of national debt.
• This is an external debt that should increase
the quantity of output from future
production, but will also involve repayment
with interest to foreigners.
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 Commonwealth government budget – surpluses and
deficits, Australia, 1974/75 to 2007/08

Source: Australian Government (2007), 2007-08 Budget Overview, Appendix G,

Historical budget and net debt data, viewed 5 May 2008, at www.ato.gov.au.
Copyright Commonwealth of Australia. Reproduced by permission.

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 Summary
• Fiscal policy; changes to government
spending and/or taxes
• Expansionary fiscal policy and
Contractionary fiscal policy
• Discretionary fiscal policy
• Automatic stabilisers
• Crowding out
• Supply side fiscal policy
• Budget deficit, budget surplus and debt
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 Self-Review Questions
• What is discretionary fiscal policy? What are
automatic stabilisers?
• What type of fiscal policy that the government
will implement in case of a recession? What are
the effects of such a fiscal policy on aggregate
demand, real GDP an the price level?
• What type of fiscal policy that the government
will implement in case of increasing inflation?
What are the effects of such a fiscal policy on
aggregate demand, real GDP an the price level?
• What is crowding out?
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