Macroeconomic policy II: fiscal policy

fiscal policy
• Fiscal policy is the use of government
spending and taxes and their influence on
the nation's economic growth, employment
and price level.
• Discretionary fiscal policy is the deliberate
use of changes in government spending
and/or taxes to alter aggregate demand
(AD) and stabilise the economy’s business
cycle.
Increasing government spending to combat a
recession
• In a period of slow economic growth,
policymakers could either:
• do nothing and wait for the private
sector to increase its demand for, and
production of, consumption and
investment foods and services; or
• increase government spending.
• With an increase in government spending,
expansionary policy through the spending
multiplier would:
• shift the AD curve outwards
• increase real GDP
• raise the price level.
Increasing government spending to combat a
recess
Marginal propensity to consume (MPC) and
The multiplier
• Initial spending by the government is
amplified because a spending multiplier
occurs:
• Those receiving the money spend some
of it on goods and services, which
creates a ripple effect.
• The proportion spent depends on the
marginal propensity to consume (MPC).
• We use this to calculate the spending
 multiplier.
The spending multiplier
• Assume the MPC is 0.75.
• Each dollar of expansionary government
spending creates 75 cents in extra
purchasing power.
• In the next round of spending, the $0.75
creates an additional $0.56 in spending
power, and then $0.42 in the next.
• An extra $1 creates $4 in extra spending.
• We can use the spending multiplier formula
to determine this amount:
1 / (1 − MPC)
• If the MPC was 0.8, the multiplier would be
5.
• If the MPC was 0.6, the multiplier would be
2.5.
Cutting taxes to combat a recession
• Cutting taxes would also expand the
 economy and help to restore full
employment.
• This policy would also:
• shift the AD curve outwards
• increase real GDP
• raise the price level.
The effect of a tax cut
• A tax cut worth $10 billion creates $10
billion extra disposable income.
• When the MPC is 0.75, this creates an extra
$7.5 billion in spending.
• This is less than the initial effect of a
spending increase since a fraction of the tax
cut is saved rather than spent.
• Thus, the tax cut results in a smaller
expansionary effect.
Using fiscal policy to combat inflation
• Contractionary fiscal policy can also be
effective against demand–pull inflation.
 • Cutting spending reduces AD (a ‘negative’
spending multiplier applies in this case).
• The rate of growth of CPI will be reduced.
• The government could also raise taxes.

The balanced budget multiplier

• This refers to an equal change in
government spending and taxes that
changes aggregate demand by the amount
of the change in government spending.
• This gives a neutral effect (zero-sum) on
government finances – a prudent way of
 financing government.
• The size of the balanced budget multiplier
is 1 – the amount of the change in
government spending.
Automatic stabilisers
• Automatic stabilisers are federal
expenditures and tax revenues that
automatically change over the course of the
business cycle in such a way as to help
stabilise an economic expansion or
contraction
• Automatic stabilisers are built-in
mechanisms that automatically help to fight
unemployment and inflation without there
being any need to explicitly alter the
spending initiatives of tax laws.
• These changes help to stabilise the
economy without the need for government
policy decisions.
• Transfer payments fall as GDP rises mainly
because unemployment falls.
• On the other hand, tax revenues and GDP
 are directly related (higher personal and
business incomes).
• Automatic stabilisation ‘leans against the
prevailing wind’.
Supply-side fiscal policy
• Fiscal policy that emphasises government
policies that increase aggregate supply to
achieve long-run growth in real output and
full employment (along with a possibly
lower price level).
Demand-side versus Supply-side fiscal policy
Microeconomic reform in Australia
• Examples of microeconomic reform in
Australia:
• reduction of tariffs
• reforms to financial system, including
the removal of interest-rate controls,
and the floating of the Australian dollar
along with the removal of foreign
exchange controls and foreign bank
entry
• competition policy reforms
• ‘Prices and Incomes Accord’
• taxation reform.
The federal budget
• The federal budget is the principal fiscal
policy statement. It presents estimated final
figures for government revenues and
expenditures for the current financial year.
• It also contains all-important forecasts of
the government’s financial situation for the
 coming four years.
• Of particular interest is the size of the
budget deficit/surplus, which is the
difference between total federal
government outlays and receipts.
• The budget outcome is of interest because:
• federal government outlays are a
considerable percentage of GDP
• the budget announces the
government’s fiscal stance.
The countercyclical role of fiscal policy
• The countercyclical role of fiscal policy
implies deficits in recessionary times offset
by surpluses (reduced government
spending and increased taxation revenue
from the higher levels of activity) in growth
periods.
• Since the 1997 budget speech, the federal
government now places an emphasis on
greater fiscal discipline to ensure that the
 federal budget remains in balance over the
course of the business cycle.
Other roles of fiscal policy
• Achieve desirable medium- to long-term
economic and social goals
• Policy initiatives in Australia have included:
• the introduction of the GST in 2000,
which broadened the tax base
• the creation of a publicly funded
private-sector job network
• mutual obligation initiatives
• limited employment subsidies
• the removal of financial disincentives.
Some words of caution
1. Need to consider the actual pattern of
expenditure and revenue. There are many
forms of tax and directions for government
spending
2. Importance of distinguishing between
 domestic deficit and the overall deficit
3. Cyclically adjusted budget deficit – the
actual recorded budget deficit adjusted for
the stage of the economy’s business cycle.
The government’s finances are
automatically affected by the varying levels
of economic activity occurring at the
different stages of the cycle
Implications of the budget outcome for
government debt levels
• Budget deficits add to government debt:
• This is the total value of outstanding
government securities.
• The Australian government’s 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.
• Money financing: When a budget deficit is
financed by the central bank purchasing the
 securities issued by the government to fund
its deficit
• Debt financing: When a budget deficit is
financed by selling government securities to
the general public – that is, by the
government borrowing from the public to
fund its expenditure.
General government debt levels as a
percentage of GDP

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.
The crowding-out issue
• Crowding out: A reduction in private-sector
spending as a result of federal budget
deficits financed by government borrowing
from the private sector
• To finance the deficit, the government must
compete for funds in the finance market,
which increases interest rates.
• High rates dissuade private-sector
spending (or borrowing to invest).
The external component of national debt
• The portion of a country’s national debt
that is owed to foreigners is a different
matter.
• At the time of writing, Australia’s debt was
 around 53 per cent of total CGS on issue.
• This is an external debt that not only should
increase the quantity of output from future
production, but will also involve repayment
with interest to foreigners.
International trade and finance
Why nations benefit from trade
• Trade allows a country to consume goods
and services in excess of its production
possibilities frontier (PPF).
• Note, from Exhibit 18.2 on the next slide,
that Australia can produce more of both
products, but is less efficient at producing
electronic equipment than agricultural
products.
• Without trade, each country would need to
produce all the agricultural products and
electronic equipment for itself and be self-
sufficient.
Specialisation with and without trade

• Before specialisation: Exhibit 18.3 on the

previous slide shows that the total two-
country world output is 90 tonnes of
 agricultural products and 30 tonnes of
electronic equipment per day.
• After specialisation: Total two-country
world output is 100 tonnes of agricultural
products and 40 tonnes of electronic
equipment per day.
• But without trade, points A (Australia) and F
(Malaysia) are not desirable production
points.
Specialisation with trade
• Specialisation allows both countries to gain
from trade.
• In our example, Australia trades 30 tonnes
of agricultural products for 20 tonnes of
electronic equipment from Malaysia.
• Malaysia trades 20 tonnes of electronic
equipment for 30 tonnes of Australian
agricultural products.
• The gain from this trade is observed, with
Australia now at point B′ and Malaysia at
 point E′.
Comparative advantage AND absolute
advantage
• Comparative advantage: The ability of a
country to produce a product at a lower
opportunity cost than another country
• Absolute advantage: The ability of a country
to produce a product using fewer resources
than another country
• In Exhibit 18.3, both countries’ decision to
specialise and trade is based on their
respective abilities to produce a good at a
lower opportunity cost than the other
country.
Comparative advantage
• For Australia, the opportunity cost of
producing 50 tonnes of electronic
equipment is 100 tonnes of agricultural
products:
• 1 tonne of electronic equipment costs 2
 tonnes of agricultural product.
• For Malaysia, the opportunity cost of
producing 40 tonnes of electronic
equipment is 40 tonnes of agricultural
products:
• 1 tonne of agricultural products costs 1
tonne of electronic equipment.
Free trade, fair trade AND protectionism
• Economists argue that international trade
should be based on comparative advantage
and free trade.
• Free trade is the flow of goods and services
between countries without restrictions or
special taxes.
protectionism
• Protectionism is the government’s use of
embargoes, tariffs, quotas and other
restrictions to protect domestic producers
from foreign competition.
• Embargoes are laws that bar trade with
 another country.
• Tariffs are taxes on imports.
• Quotas are limits on the quantity of a
good that may be imported.
FAIR TRADE, THE ‘FAIR TRADE MOVEMENT’
AND STRATEGIC TRADE
• Fair trade is a term used to represent the
view that a country should only reduce its
barriers to imports from another country if
the other country does not have some sort
of ‘unfair’ competitive advantage over it
and the other country is also willing to
reduce its import barriers reciprocally.
• There is also the growing concern in the
developed world about issues such as
international differences in workplace health
and safety regulation, the use of child
labour and the lack of appropriate
environmental regulation in many
developing countries.
• Strategic trade theory is the idea that
governments should seek to be strategic in
their use of their spending and taxing
powers to actively facilitate some sectors of
the economy that they feel may have the
potential to be strong export earners for
their nations.
• Proponents of this theory argue that a
country’s comparative advantages are not
static.
• They argue that nations can develop
comparative advantages over other nations
by careful and selective support for some
domestic industries over others.
• Example: Singapore.
• Critics argue that the private sector is better
placed, and better skilled, to develop export
opportunities.
• Example: ‘Hong Kong followed a
market-based approach to developing
its export markets with little
 “interference” from the government.’
Political economy of reducing barriers to
trade
• Narrow special-interest groups have
political influence.
• Employees and owners of import-
competing firms have a great deal at stake;
for example:
• reduced incomes
• employees losing jobs.
Some common (but specious) arguments for
protection
1. Infant industry argument
2. National security argument
3. Employment argument
4. Cheap foreign labour argument
Free trade (or preferential trade) agreements
• A number of free trade agreements (FTAs)
have been negotiated over the years to
 enable the free flow of capital, labour and
investment; for example:
• In Europe, 15 nations in 1958 joined
together to form the European
Economic Community (EEC).
• In 1993, the US entered into an FTA
with Canada and Mexico called the
North American Free Trade Agreement
(NAFTA).
• Critics argue that these FTAs are the
foundation of protectionist trading blocs.
The balance of payments (BOP)
• The balance of payments (BOP) is a
summary record of the international
transactions between a country and others
during a given period of time.
• This summary records the nature and value
of inflows and outflows of goods, services
and financial assets.
Australia’s bop, 2019–20
AUSTRALIA’S CURRENT ACCOUNT BALANCE,
1959–60 to 2019–20

Capital and financial account

• The capital and financial account records
dollar payment flows on account of
purchases of foreign assets by Australians
or purchases of Australian assets by
foreigners.
• Examples: purchasing shares or bonds,
extending loans, buying government
securities or directly purchasing
 property
The capital/Financial and current accounts
exactly offset
• The current and capital/financial accounts
should balance. (Any difference is a
measurement error.)
• This is because any deficit on the current
account is financed by a surplus on the
capital account.
• Foreigners accommodate additional current
expenditure by becoming investors in the
country.
Are current account deficits a bad thing?
• The current account deficit is not likely to
prove a problem provided overseas funds
are used to finance investment goods that
earn income in the future.
• The current account deficit and
capital/financial account surplus have
allowed Australia to achieve higher rates of
 economic growth than would otherwise
have been possible.
AUSTRALIA’S FOREIGN LIABILITIES
• There has been a gradual rise in net foreign
liabilities and debt over the past 27 years.
• Total net foreign liabilities stood at around
43% in 1990; and by 2020, they stood at
45%.
• Much of this is explained by the financial
deregulation and freeing up of international
financial markets that have occurred since
1990.
• Note that recent very low servicing ratios
are a reflection of the very low levels of
international interest rates prevailing in the
post-GFEC years, and the fact that all of
Australia’s net foreign liabilities were, by
2014, comprised of net foreign debt.
Supply and demand for foreign exchange
Shifts in supply and demand for foreign
exchange
• Flexible exchange rate system is a system in
which countries allow their currencies to
adjust continuously according to the forces
of supply and demand.
• There are four sources of shifts in supply
and demand:
• changes in tastes and preferences
across countries
• changes in relative incomes across
 countries
• changes in relative price levels across
countries
• changes in relative real interest rates
across countries.
Appreciation and depreciation
• Changes in any of the four sources affect
the currency value in terms of appreciation
or depreciation.
• Appreciation is a rise in the price of one
currency relative to another.
• Depreciation is a fall in the price of one
currency relative to another.
The economic impact of exchange rate
fluctuations
• Ceteris paribus, a lower-value AUD
increases the competitiveness of the
country’s exports and import-competing
industries.
• Exports seem cheaper to foreigners, and
 imports are more expensive to Australians.
• A higher AUD has the opposite effect.