Fiscal policy Flashcards
what is discretionary fiscal policy
When the government is taking actions to change spending or taxes to achieve its economic objectives (fiscal policy)
automatic stabilisers
Transfer payments and taxes that automatically increase or decrease along with the business cycle.
draw the diagram of an expansionary fiscal policy
describe this diagram
Economy begins at equilibrium at $1200 real GDP and price level of 100
Year 2: LRAS1 shifts to LRAS2, AD1 shifts to AD2(w/o policy) which is below potential GDP (recession, workers sacked, profits fall) SRAS1 shifts to SRAS2. economy will be at short-run equilibrium
increasing gov expenditure and/or reduce taxes will shift AD1 to AD2(w policy). Equilibrium at C, which is at potential GDP
draw diagram of the effect a contractionary fiscal policy would have on the economy
explain the diagram
The economy begins in equilibrium at point A, at potential GDP of $1200 billion and a price level of 100.
LRAS increases to $1400 billion in the second year.
The shift in aggregate demand from AD1 to AD2(without policy) results in a short-run macroeconomic equilibrium beyond potential GDP of $1450 billion (point B).
The economy will experience a rising inflation rate, with the price level rising from 100 to 104.
Decreasing government purchases or increasing taxes will shift AD1 to AD2(with policy) and keep real GDP from moving beyond its potential level. The inflation rate is 3 per cent rather than 4 per cent, and real GDP is at its potential level of $1400 billion
Multiplier effect
process by which an increase in autonomous expenditure leads to a larger increase in real GDP.
spending and real GDP increase over a number of periods
draw a diagram to show the multiplier effect from an increase in gov purchase
The shift to the right from AD1 to AD2 shows
the initial increase in government purchases raises incomes and leads to further increases in consumption spending, the aggregate demand curve will ultimately shift further to the right, to AD3.
The multiplier effect will continue over a number of periods, with
the additional consumption spending in each period being half of the income increase from the previous period. Eventually, the process will be complete,
what is the government purchases multiplier:
ratio of the change in equilibrium real GDP to the initial change in government purchases
describe how tax cuts have a multiplier effect
an inital tax cut increases disposable income –> increases consumption –> set off further increases in real GDP and income
tax multiplier equation
tax multiplier = change in equilibrium GDP/ change in taxes
is tax multiplier a negative no?
yes
if the tax multiplier is –1.6, a $10 billion cut in taxes
how much will it increase real GDP
will increase real GDP by –1.6 × –10 billion = $16 billion.
why may there be a smaller increase in aggregate demand when there is an increase in government purchases
a portion will be saved or a portion might be spent on imports
what effect does a change in tax rates have on equilibrium real GDP?
The higher the tax rate –> the smaller the amount of any increase in income that households have available to spend –> reduces the size of the multiplier effect
a cut in tax rates affects equilibrium real GDP through two channels
(1) a cut in tax rates increases the disposable income of households, which leads them to increase their consumption spending, and
(2) a cut in tax rates increases the size of the multiplier effect.
multiplier effect and aggregate supply
draw diagram
describe this diagram
The economy is initially at point A.
An increase in government purchases causes the aggregate demand curve to shift to the right, from AD1 to AD2.
The multiplier effect results in the aggregate demand curve shifting further to the right, to AD3 (point B).
Because of the upward-sloping supply curve the shift in aggregate demand results in a higher price level.
new equilibrium at point C, both real GDP and the price level have increased. The increase in real GDP is less than indicated by the multiplier effect with a constant price level
describe the multiplier effect of decreases in gov purchases and increases in taxes
an increase in taxes –> reduce household disposable income –> reduce consumption spending –> reduced sales –> firms cut back on production –> lay off workers –> fall income –> reduced consumption
Real GDP is currently $1200 billion, and potential GDP is $1250 billion. If the government increased government purchases by $50 billion or cut taxes by $50 billion, the economy could be brought to equilibrium at potential GDP.’
true or false?f
false, multiplier effect not considered.
Because of the multiplier effect, an increase in government purchases or a decrease in taxes of less than $50 billion is necessary to increase equilibrium real GDP by $50 billion. For instance, assume that the government purchases multiplier is 2 and the tax multiplier is –1.6
Gov purchases multiplier = change in equilibrium real GDP/ change in gov purchases
2= 50/ change in gov purchases
change in gov purchaes = 25
Tax multiplier = change in equilibrium real GDP/ change in taxes
-1.6 = 50/change in taxes
change in taxes= -31.25
Getting the timing right can be more difficult with fiscal policy than with monetary policy for two main reasons.
- reserve bank can change monetary policy monthly at montly meetings or any time by calling a special meeting
- change in fiscal policy made through budget in May annually. Must pass through Lower and Upper House which can take many months
describe why it may take a while to implement fiscal policy
e.g. $10b to construct railway lines –> months for detailed construction plans –> state gov asks for bids from private construction companies –> winnings bidders selected –> several months before project begins
it takes time for policy-makers to collect statistics and identify changes in the economy. It can also take a substantial amount of time for the government to
formulate policy and get it passed through parliament.
the size of the multiplier effect may be limited if
if gov expenditure causes crowding out
what is crowding out
A decline in private expenditure as a result of an increase in government purchases.
explain the crowding out effect (financial crowding out specifically)
gov spends w/o increasing taxation –>
most likely operating with budget deficit –>
borrows money by issuing cth bonds and securities –>
borrow from domsetic market, demand for loanable funds increase and real interest rate increases –>
reduced consumption and investment and net exports
if government borrowing occurs on global financial markets, ( by selling securities and bonds) what effect does it have on domestic interest rates
no effect
what is another way gov borrowing can cause interest rates to rise?
give an example
if government borrowing for spending programs increases aggregate demand by an amount that puts upward pressure on inflation
Australian government was borrowing around $1 million each day to fund stimulus infrastructure programs that were continuing even though the rate of economic growth was returning to a healthier level.
inflationary pressures that led the RBA to increase interest rates 4 times during 2010.
when might crowding out not be a problem
In a deep recession when many firms are very pessimistic about the future where investment spending falls to very low levels and is unlikely to fall much further even if interest rates rise.
If the economy is close to potential GDP, will crowding out be a problem
an increase in interest rates may result in a significant decline in investment spending
what is another way that gov expenditure can cause crowding out i.e. decline in private expenditure?
paying off government debt in the future will require higher taxes in the future, which can depress economic growth.
describe when resource crowding out may occur
what happens?
If increases in government spending occurred at a time when the economy was near or at full capacity, the government would be taking resources that would otherwise be used by the private sector.
due to limited resources, the price for resources will rise
What is the long-run effect of a permanent increase in government spending?
distinguish with crowding out effect in the short-run
most economists agree that the result is complete crowding out. private expenditure falls by the same amount gov expenditure has increased e.g. before 20% G and 80% private .
After 30% G and 70% private
- Gov expenditure comes at the expense of private expenditure
cf partial crowding out in short-run
An expansionary fiscal policy does not have to cause complete crowding out in the short run.
how come?
If the economy is below potential GDP it is possible for both government purchases and private expenditure to increase.
what is net debt
he difference between the amount of funds the government borrows and the amount it lends
Describe trend of government debt
The Coalition government consistently reduced the net debt of the Commonwealth government throughout the period after 1995/96 and by 2005/06 the government had no net debt, and had become a net saver
. Australia moved into a position of significant debt from 2008/09 onwards, as government borrowing was required to fund the budget deficit
why do budget deficits occur during contractions or recessions?
due to automatic stabilisers
cyclically adjusted budget deficit or surplus measures?
The cyclically adjusted budget deficit or surplus measures what the deficit or surplus would be if the economy were at potential GDP
how does the GDP level affect the cyclically adjusted budget deficit?
if real GDP is above potential GDP, budget will be in surplus (increase in taxes, reduction in transfer payments)
if real GDP is below potential GDP, budget will be in deficit (fall in taxes, rise in revenue)
if real GDP = potential GDP, budget will be balanced
The federal government’s budget in Australia was in deficit by over $15 billion in 1993 and moved into a surplus of over $12 billion in 2000. Someone commented, ‘The government must have acted to raise taxes or cut spending or both’.
false
could also be that household incomes and firms profits rose –> increase in tax and unemployment fell –> fall in transfer
Should the federal budget always be balanced?
To balance the budget every year the government might have to take actions that would destabilise the economy.
e. g. balance budget during contraction (GDP below potential level) where budget automatically moves into a deficit –> increase in taxes etc. –> reduces aggregate demand and further slows down growth
e. g. balanced budget during expansion (GDP above potential leve) where budget automatically moves into a surplus –> to balance, cut taxes and increase spending –> inflationary pressures
how does the gov pay its interest on the debt?
what is the problem if the gov has a very high debt level?
raise funds through taxes to pay debts
higher the debt –> more tax needs to be raised or cut back on spending
crowding out effectively reduces private investment spending
less investment means?
how can this be somewhat offset?
Lower investment spending means lower capital stock in the long run and a reduced capacity of the economy to produce goods and services.
somewhat offset if some of the government debt is incurred to finance improvements in infrastructure, education or R&D –> add to productive capacity
distinguish between the effect of short-run and long-run fiscal policy actions
short-run: stabilise economy
long run: increase productivity –> long-term growth concerned with supply side policies –> shifts LRAS supply curve to the right
Most fiscal policy actions that attempt to increase aggregate supply do so by
changing taxes to increase the incentives to work, save, invest and start a business.
The long-run effects of tax policy
what is a tax-wedge
The difference between the pre-tax and post-tax return to an economic activity.
reducing the tax wedge by cutting the marginal tax rate on income would
would result in a larger quantity of labour supplied because the after-tax wage would be higher
In general, economists believe that the smaller the tax wedge for any economic activity
the more of that economic activity that will occur.
effects on aggregate supply
reducing the marginal tax rates on personal income
reduces the tax wedge faced by workers –> increases quantity of labour supplied.
sole proprietorships, whose profits are taxed at the personal income tax rates. –> encourages entrepreneurship, encouraging the opening of new businesses.
households are also taxed on their returns from saving at the personal income tax rates –> Reducing marginal income tax rates therefore also increases the return to saving.
effects on aggregate supply
Company income tax.
Cutting the company income tax rate would encourage investment spending by increasing the return corporations receive from new investments in equipment, factories and office buildings.
innovations are often embodied in new investment goods –> increase the pace of technological change.
effects on aggregate supply
Taxes on capital gains
earnings are, in effect, taxed twice: once when corporations pay the company income tax on their profits, and again when the profits are received by individual investors in the form of capital gains.
Lowering the tax rates on capital gains increases the supply of loanable funds from households to firms, increasing saving and investment and lowering the equilibrium real interest rate.
draw the supply side effects of a tax change
explain this diagram
equilibrium is at point A
No tax change, shifts from LRAS1 to LRAS2 new equilibrium at B
With tax reductions and simplifications the long-run aggregate supply curve shifts further to the right to LRAS3 and equilibrium moves to point C (further increasing real GDP and lowering price)
Economists who are sceptical of the magnitude of supply-side effects believe that
believe that tax cuts have their greatest impact on aggregate demand, rather than on aggregate supply
Most economists would agree that there are supply-side effects to
reducing taxes: decreasing marginal income tax rates will increase the quantity of labour supplied, cutting the company income tax will increase investment spending and so on. The magnitude of the effects is the subject of considerable debate,
why is the magnitude of supply side effects of tax changes debatable?
economists believe that tax changes have only a small effect on saving and investment.
in their view, saving and investment are affected much more by changes in income or changes in expectations of the future profitability of new investment due to technological change or improving macroeconomic conditions than they are by tax changes.
draw the phillip’s curve
what does it show
short-run relationship between unemployment rate and inflation
If aggregate demand does not increase by as much as LRAS, short-run macroeconomic equilibrium will occur at
what if it shifts by the same amount?
a level of real GDP below the potential level.
But if it shifts at the same amount, the the economy can remain in macroeconomic equilibrium at potential GDP.
he unemployment rate will rise, but the price level will rise by less than it would have, meaning that the inflation rate will fall.
describe the following diagram
if aggregate demand was strong
and draw the corresponding phillip’s curve
In year 2, if the AD curve shifts to the right by the same amount as the LRAS curve, then macroeconomic equilibrium occurs at real GDP of $1450 billion, which is the new higher level of potential GDP (point B).
The price level rises from 100 to 104, so the inflation rate remains at 4 per cent. Point B on the Phillips curve is the same as point A because the inflation and unemployment rates haven’t changed.
describe the following diagram
if aggregate demand was weak
and draw the corresponding phillip’s curve
Year 2: macroeconomic equilibrium occurs below potential GDP. Inflation falls to 2% and unemployment rises to 6%
the AD–AS model indicates that slow growth in aggregate demand leads
what does this explain
both higher unemployment and lower inflation.
This relationship explains why there is a short- run trade-off between unemployment and inflation
Is the Phillips curve a policy menu?
During the 1960s some economists argued that the Phillips curve represented a
structural relationship in the economy: a structural relationship depends on the basic behaviour of consumers and firms and remains unchanged over long periods
Is the Phillips curve a policy menu?
Structural relationships are useful in formulating economic policy because
policy-makers can anticipate that these relationships are constant—that is, the relationships will not change as a result of changes in policy.
Is the Phillips curve a policy menu?
potentially, if the phillips curve were a structural relationship,
Potentially, policy-makers could use expansionary/contractionary monetary and fiscal policies to choose a point on the curve that had lower unemployment and higher inflation.
Is the Phillips curve a policy menu?
Because many economists and policy-makers in the 1960s viewed the Phillips curve as a structural relationship
they believed it represented a permanent trade-off between unemployment and inflation.
Is the Phillips curve a policy menu?
describe the permanent trade-off between unemployment and inflation
As long as policy-makers were willing to accept a permanently higher inflation rate, they would be able to keep the unemployment rate permanently lower
Similarly, a permanently lower inflation rate could be attained at the cost of a permanently higher unemployment rate.
what features of the 1960s held that there was a stable trade-off between inflation and unemployment?
early 1960s the inflation rate in many industrialised countries was low, while the unemployment rate was high.
late 1960s the unemployment rate had declined, while the inflation rate had increased.
Who argued that the phillip’s curve did not present a permanent trade off?
who supported this?
US economist Milton Friedman in 1968 argued that the Phillips curve did not represent a permanent trade-off between unemployment and inflation
US economist Edmund Phelps published an academic paper making a similar argument
why did friedman and phelps argue there was no trade off in the long-run between unemployment and inflation?
b/c LRAS curve is vertical so the phillip curve could not be downward sloping in the long run
the level of real GDP in long run is also referred to as
potential GDP
what will happen to real GDP and unemployment in the short-run and long-run?
it the short-run they will fluctuate
in the long-run they will return to potential GDP or the natural rate of unemployment (unemployment when economy is operating at potential GDP)
- inflation has no effect on real GDP(always=potential GDP) and unemployment (always= natural rate)
draw the long-run phillip’s curve and LRAS curve according to Friedman and Phelps
what implication can be drawn If the long-run Phillips curve is a vertical line
no trade-off exists between unemployment and inflation in the long run
If the long-run Phillips curve is a vertical line, then no trade-off exists between unemployment and inflation in the long run, how can you experience the trade-off in the 1950s and 60s?
How did Friedman justify?
Friedman argued that the statistics from those years actually showed only a short-run trade-off between inflation and unemployment.
The short-run trade-off existed differences between the expected inflation rate and the actual inflation rate (by workers and firms) could lead the unemployment rate to rise above or dip below the natural rate
calculate real wage
company’s managers and the unions agree on a wage of $31.50 per hour to be paid during 2015. Both the company and the unions expect that the price level will increase from 100 in 2014 to 105 in 2015, so the inflation rate will be 5 per cent.
Real wage= nominal wage/price level x 100= $31.50/105 x 100= $30
impact of unexpected price level changes on the real wage
company’s managers and the unions agree on a wage of $31.50 per hour to be paid during 2015. Both the company and the unions expect that the price level will increase from 100 in 2014 to 105 in 2015, so the inflation rate will be 5 per cent.
If inflation rate was 2% during 2015?
if the inflation rate was 8% during 2015?
If actual inflation is higher than expected inflation
then
actual real wages in the economy will be lower than expected real wages and many firms will hire more workers than they had planned. Therefore, the unemployment rate will fall.
If actual inflation is lower than expected inflation,
actual real wages will be higher than expected and many firms will hire fewer workers than they had planned, and the unemployment rate will rise.
Friedman and Phelps concluded that
an increase in the inflation rate increases employment (and decreases unemployment) only if the increase in the inflation rate is unexpected.
If workers fail to understand that rising inflation leads over time to comparable increases in wages, then, when inflation increases, in the short run
firms can increase wages by less than inflation without needing to worry about workers quitting or their morale falling.
Once again, we have a higher inflation rate leading in the short run to lower real wages and lower unemployment.
