L10: Fiscal Policy

Nikhil Damodaran

Semester 01, 2024

Lecture 10 1 / 36
 This Chapter
1. Agenda
2. 13.1. Scope of Fiscal Policy
2.1 Automatic Stabilizers vs. Discretionary Fiscal Policy
2.2 Australian Government Spending: Some Facts
3. Fiscal Intervention
3.1 Expansionary Fiscal Policy
3.2 Contractionary Fiscal Policy
4. Multipliers
4.1 Government purchases multiplier
4.2 Tax Multiplier
4.3 Balanced Budget Multiplier
4.4 Tax Rate Changes
4.5 Multipliers: Some Remarks
5. Limitations of Fiscal Policy
5.1 Time Lags
5.2 Crowding Out
6. Debt and Deficits
6.1 Structural Deficits
6.2 Sovereign Debt
7. Fiscal Policies in the Long Run
7.1 Tax Reforms in the long run

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 Agenda

Chapter 13: Fiscal Policy

✓ Define fiscal policy. (13.1)

✓ Explain how fiscal policy affects aggregate demand and how the government can use fiscal
policy to stabilise the economy. (13.2)
✓ Explain how the government purchases and tax multipliers work. (13.3)
✓ Discuss the difficulties that can arise in implementing fiscal policy. (13.4)
✓ Define federal budget deficit and federal government debt and explain how the federal
budget can serve as an automatic stabiliser. (13.5)
✓ Discuss the effects of fiscal policy in the long run. (13.6)

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 13.1. Scope of Fiscal Policy

◦ Fiscal policy: Changes in federal taxes and purchases that are intended to achieve
macroeconomic policy objectives, such as high employment, price stability and healthy
rates of economic growth.
◦ Anything which the government which amounts to direct intervention in markets is traditional
fiscal policy.

◦ Fiscal policy refers to the actions of the federal government, and not state, territory or local
governments
◦ Introducing state fiscal policy will complicate the analysis. This is a convenient abstraction.

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 Automatic Stabilizers v. Discretionary Fiscal Policy

◦ Automatic stabilizers – the part of fiscal policy which is linked to various economic variables
which go up and down due to seasonal, cyclical, structural or other unanticipated
circumstances.

◦ When GDP increases, income tax revenue goes up.

◦ When unemployment increases, unemployment benefits rise.

◦ Here, income tax revenue and unemployment benefits follow business cycles, hence
“automatic”. The policy makers do not have to intervene. But not all kinds of fiscal policy is
automatic, some are based on “discretionary” choice.

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 Federal Government Spending in Australia

Government expenditure as a proportion of GDP increased by a large amount during the early to mid-1970s and trended downwards
during the 1990s and into the 2000s, a result of the microeconomic reform policies of governments during this time. By 2006/2007,
government expenditure as a proportion of GDP was around 23 per cent. Between 2008 to 2010, government expenditure as a
proportion of GDP rose, peaking at 26 per cent of GDP in 2009/2010. Although it fluctuated, after 2010, government expenditure as
a proportion of GDP generally remained higher than it had been during the 2000s.
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 Where does the government spend?

The largest share of government expenditure in Australia goes to social security and welfare payments, at over 35 per cent in the
2016/2017 financial year. The second largest single share of total government expenditure is health, at almost 16 per cent, followed
by education at 7.5 per cent.
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 How does it pay for the expenses?

The largest proportion of government revenue comes from personal income taxation. For the 2016/2017 financial year, almost 48 per
cent of federal government revenue came from individual income taxation. The second largest source of revenue is from company
income taxation, at around 17 per cent of total revenue.
Lecture 10 13.1. Scope of Fiscal Policy 8 / 36
 Expansionary Fiscal Policy

◦ When: aggregate demand is less than desired. AD < Y ∗ (potential output)

◦ “Desired” both in terms of long and short run are the same i.e. AD = SRAS = LRAS.

◦ Government can increase its own spending as a part of aggregate demand

AD (↑) = C + I + G(↑) This affects AD directly.

◦ Government can reduce direct taxes on income or indirect taxes on expenditure to increase
AD indirectly by altering incentives.
◦ A reduction in direct taxes increases disposable income. For eg: if income taxes are reduced,
you have more income left after taxes.
◦ A reduction in indirect taxes increases real incomes as the prices of goods tend to reduce as
firms pass on the reduction in taxes as lower prices.

Lecture 10 Fiscal Intervention 9 / 36

 Expansionary Fiscal Policy

The key idea for this figure is that the economy was initially at point A, which is a long run equilibrium. Overtime its capacity (LRAS),
its short run supply (SRAS) and its demand (AD) moves to the right. In this case, AD does not move right enough so in the short run
the economy is stuck at B. If policy is not introduced, then the economy will only slowly adjust and reach C. If policy is used, then the
economy reaches to C in a shorter time span.
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 Contractionary Fiscal Policy

◦ When: aggregate demand is more than desired. AD > Y ∗ (potential output)

◦ “Desired” both in terms of long and short run are the same i.e. AD = SRAS = LRAS.

◦ Government can reduce its own spending as a part of aggregate demand

AD (↓) = C + I + G(↓) This affects AD directly.

◦ Government can increase direct taxes on income or indirect taxes on expenditure to reduce
AD indirectly by altering incentives.
◦ An increase in direct taxes reduces disposable income. For eg: if income taxes are increased,
you have less income left after taxes.
◦ An increase in indirect taxes reduces real incomes as the prices of goods tend to increase
when firms pass on the increase in indirect tax.

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 Contractionary Fiscal Policy

The key idea for this figure is that the economy was initially at point A, which is a long run equilibrium. Overtime its capacity (LRAS),
its short run supply (SRAS) and its demand (AD) moves to the right. In this case, AD moves too far right so in the short run the
economy is at B. If policy is not introduced, then the economy will only slowly adjust and reach C. If policy is used, then the economy
reaches to C in a shorter time span. The key difference is that for a contraction, government either needs to reduce its own spending
or create incentives which force other people to spend less.
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 How do we identify whether economy needs contractionary or expansionary
fiscal policies?

Problem Figure Policy Expected result

Recession B is less than Expansionary: Increase RGDP ↑ and P ↑ because
potential government spending AD ↑ directly.

Lecture 10 Fiscal Intervention 13 / 36

 How do we identify whether economy needs contractionary or expansionary
fiscal policies?

Problem Figure Policy Expected result

Recession B is less than Expansionary: Increase RGDP ↑ and P ↑ because
potential government spending AD ↑ directly.
B is less than Expansionary: Reduce RGDP ↑ and P ↑ because C
Recession potential direct taxes or I ↑, AD ↑ indirectly.

Lecture 10 Fiscal Intervention 13 / 36

 How do we identify whether economy needs contractionary or expansionary
fiscal policies?

Problem Figure Policy Expected result

Recession B is less than Expansionary: Increase RGDP ↑ and P ↑ because
potential government spending AD ↑ directly.
B is less than Expansionary: Reduce RGDP ↑ and P ↑ because C
Recession potential direct taxes or I ↑, AD ↑ indirectly.

B is more than Contractionary: Reduce RGDP ↓ and P ↓ because

Expansion potential government spending AD ↓ directly.

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 How do we identify whether economy needs contractionary or expansionary
fiscal policies?

Problem Figure Policy Expected result

Recession B is less than Expansionary: Increase RGDP ↑ and P ↑ because
potential government spending AD ↑ directly.
B is less than Expansionary: Reduce RGDP ↑ and P ↑ because C
Recession potential direct taxes or I ↑, AD ↑ indirectly.

B is more than Contractionary: Reduce RGDP ↓ and P ↓ because

Expansion potential government spending AD ↓ directly.
B is more than Contractionary: Increase RGDP ↓ and P ↓ because C
Expansion potential direct taxes or I ↓, AD ↓ indirectly.

Lecture 10 Fiscal Intervention 13 / 36

 Multipliers
◦ Multiplier effect: The process by which an increase in autonomous expenditure leads to a
larger increase in real GDP.

◦ Consider the following simple model economy:

C =C̄ + c (Y − T )
I =Ī
G =Ḡ
T =T̄
equilibrium condition
z }| {
Y ≡C+I+G

◦ Equilibrium is to solve for Y

C̄ − c T̄ + Ī + Ḡ
Y =
1−c

Lecture 10 Multipliers 14 / 36
 Multipliers

◦ Change in autonomous variables (C̄, T̄ ,Ḡ and Ī) are:

∆C̄ c ∆T̄ ∆Ī ∆Ḡ

∆Y = − + +
1−c 1−c 1−c 1−c

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 Government purchases multiplier

◦ Multipliers for government purchases for the above model can be calculated as:
∆Y 1
=
∆Ḡ 1−c

◦ Government purchases multiplier: is a measure of the effect of changes in exogenous

government purchases on the GDP of an economy.
∆Y
◦ ∆Ḡ
: denotes the multiplier for a change in exogenous government purchases, Ḡ
represents the fact that the spending is exogenous i.e. does not depend on GDP levels.

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 Government purchases multiplier: Intuition

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 Government purchases multiplier: Intuition

◦ Why does this occur? Because each time someone spends money, someone else earns it.
This person in-turn spends it, making the third persons earning and so on. Every one time
spending thus creates multiple rounds of income generation. If we measure the effect of the
first spending after the economy reaches new equiliibrium, we get the multiplier.

◦ Increase in government spending has a direct effect.

◦ But it also has an indirect effect because of a general increase in income.

◦ Total effect is greater than direct effect. How much more depends on how much of income
is consumed

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 Government purchases multiplier: Intuition

◦ Example: A $100 increase in Ḡ has $100 direct effect on Y. $100 increase in Y increases
consumption C by $c = 0.4 = 40$ (MPC) which adds further to the increase in Y. Why?
Government build roads, employs people. They now have incomes which they go and
spend on their consumption.

◦ This $c = $40 increase in Y further increases consumption C by $c × c which adds further

to the increase in Y

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 Tax Multipliers

◦ Tax multiplier: is a measure of the effect of changes in tax rates on the GDP of an economy.
◦ The tax multiplier for the model developed so far is:
∆Y −c
=
∆T̄ 1−c

◦ Increases in government purchases and cuts in taxes have a positive multiplier effect on
equilibrium real GDP. Decreases in government purchases and increases in taxes have a
negative multiplier effect on equilibrium real GDP.

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 Balanced Budget Multiplier

◦ If we assume that Ḡ = T̄ i.e. budgets are balanced for our model, then we obtain a
balanced budget multiplier.
1
◦ Consider c = 0.75. Then the government spending multiplier is 1−c
= 4. This implies that
if government spending increases by 10$ bn, then output increases by 40$ bn.

◦ However, since Ḡ = T̄ , when government spending increases by 10$ bn, then taxes should
increase by 10$ bn too!
−0.75
◦ This implies a tax multiplier of 0.25
= −3. Hence an increase in tax by 10$ bn causes
output to fall by 30$ bn.
∆Y
◦ Net impact on output is +10$ bn. So the balanced budget multiplier is ∆Ḡ
= 1.

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 Tax Rate Changes: Government Purchases Multipliers

◦ Now consider a model in which tax revenue is not the exogenous instrument. Instead,
policy maker controls tax rates τ . This complicates the calculation of government
purchases multiplier.

C =C̄ + c (Y − T )
I =Ī G = Ḡ T = τY
∆Y 1
=
∆Ḡ 1 − c (1 − τ )
◦ The value of the tax rate (τ ) affects the size of the multiplier effect. (a) The higher the tax
rate the smaller the multiplier effect. (b) A cut in the tax rate increases the size of the
multiplier effect.

◦ Note: For tax rate changes, now we can only calculate the balanced budget multiplier i.e. to
ask what happens to output when tax rate changes if these changes lead to changes in
government spending.
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 Multipliers: Some Remarks
If producers supply any quantity in the short run at the ongiong price, then multipliers can be
larger and fiscal policy can work wonders! The upward-sloping aggregate supply curve causes
the price level to rise as aggregate demand increases.

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 Multipliers: Some Remarks

◦ The multipliers work in both directions.

◦ Both expansionary and contractionary fiscal policy have a multiplier effect.

◦ An increase in taxes will reduce household disposable income and consumption spending

◦ Businesses hit by this reduction in spending will lower production and lay off workers

◦ Falling incomes lead to further reductions in consumption spending.

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 Limitations of Fiscal Policy

◦ Timing Lags: the average time from identifying an economic problem to addressing it can
take upto two quarters, if not more.

◦ Reinhart and Rogoff show facts about the 2008-09 financial crisis. For eg: unemployment rate
increased from 5% to 12% in a matter of a year.

◦ The fact that there was this consistent increase for over two years implies that government
policy either (a) could not prevent it or (b) didnt do enough in time.

◦ Real GDP per capita also declined sharply, and the average length of a recession following a
financial crisis has been nearly two years.

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 Crowding Out

◦ Crowding Out: is the idea that when government intervenes in the market, it competes for
resources which makes it expensive for private players to operate and hence forces them to
exit the market.

◦ Most economists agree that there is partial crowding out in the short run, and complete
crowding out in the long run. i.e. there is no long-run effect on GDP from a permanent
increase in government spending.

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 Crowding Out

◦ Crowding Out: is the idea that when government intervenes in the market, it competes for
resources which makes it expensive for private players to operate and hence forces them to
exit the market.

◦ Most economists agree that there is partial crowding out in the short run, and complete
crowding out in the long run. i.e. there is no long-run effect on GDP from a permanent
increase in government spending.

◦ Financial crowding out example: To finance a budget deficit, the government will sell more
bonds and securities, which may increase interest rates. This increase in rates slows down
investments because of higher cost of borrowing.

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 Crowding Out

◦ Crowding Out: is the idea that when government intervenes in the market, it competes for
resources which makes it expensive for private players to operate and hence forces them to
exit the market.

◦ Most economists agree that there is partial crowding out in the short run, and complete
crowding out in the long run. i.e. there is no long-run effect on GDP from a permanent
increase in government spending.

◦ Financial crowding out example: To finance a budget deficit, the government will sell more
bonds and securities, which may increase interest rates. This increase in rates slows down
investments because of higher cost of borrowing.

◦ Resource crowding out example: Government spending can lead to demand for labor, which
can take workers away from other jobs. This causes other sectors to compete for workers and
pay workers more, leading to upward pressure on prices.

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 Debt and Deficits

◦ Budget deficit: The situation in which the government’s expenditures are greater than its tax
revenue.

◦ Budget surplus: The situation in which the government’s expenditures are less than its tax
revenue.

◦ Implication: If the government has a budget deficit, this has to be financed by borrowing,
which contributes to net debt.

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 Debt and Deficits

Budget surplus or deficit

Lecture 10 Debt and Deficits 28 / 36
 Debt and Deficits

Net debt
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 Debt and Deficits

◦ Every year, government budget constraint is

uses of funds sources of funds
z }| { z }| {
Gt + iBt + Transferst = Taxest + (Bt +1 − Bt )

where:
Gt = government purchases of goods and services
iBt = interest payment on existing government debt
Bt +1 − Bt = change in government debt.
Note that Bt +1 will be repayable next year and Bt is repayable this year.
Transferst = transfer payments by government
Taxest = tax revenue
Let: Tt = Taxest − Transferst

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 Debt and Deficits

◦ Amount of government debt Bt .

◦ Government deficit is the change in government debt:
expenses income
z }| { z}|{
Bt +1 − Bt = Gt + iBt − Tt

◦ When Bt +1 − Bt > 0 debt increases and when Bt +1 − Bt < 0 debt decreases

◦ Primary deficit: Gt − Tt .
◦ Federal government deficits increase automatically during economic contractions and
recessions because: (a) tax revenues fall Taxest ↓ when Yt ↓ and (b) unemployment benefit
payments increase i.e. Transferst ↑ when Yt ↑

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 Structural Deficit

The deficit or surplus in the federal government’s budget if the economy were at potential GDP provides a more accurate measure of
the impact on the economy of government expenditure and taxation policies

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 Sovereign Debt

◦ Should government budgets be balanced always?

◦ When the economy is contracting, or in a recession, tax revenues fall and government
spending rises, moving the budget into a deficit.
◦ When actual GDP is above its potential level during a boom, the budget automatically moves
into a surplus—tax revenues rise.
◦ Maintain a balanced budget every year could involve policies that might destabilise the
economy.

Lecture 10 Debt and Deficits 33 / 36

 Sovereign Debt

◦ Should government budgets be balanced always?

◦ When the economy is contracting, or in a recession, tax revenues fall and government
spending rises, moving the budget into a deficit.
◦ When actual GDP is above its potential level during a boom, the budget automatically moves
into a surplus—tax revenues rise.
◦ Maintain a balanced budget every year could involve policies that might destabilise the
economy.

◦ Is government debt a problem?

◦ At times, government debt may be necessary, e.g. during an economic contraction or
recession.
◦ Sustainability of debt is based on whether rate of growth of GDP (g) is greater than rate of
interest of servicing debt (r). r > g indicates difficulty in sustainability, though these rules are
guidelines.
◦ Debt servicing (interest repayments) involves an opportunity cost.

Lecture 10 Debt and Deficits 33 / 36

 Fiscal Policies in the Long Run

◦ Supply side fiscal policy: i.e. fiscal policies designed to shift the LRAS to the right by
improving the productive capacity of an economy.

◦ Eg: investments in technology, research and development or designing migrant friendly

policies.

◦ Optimal Taxation: is the idea of designing a tax system such that the post tax output is
greater than or equal to pre-tax output.

◦ Usually, zero income and capital gains taxes increase output for most economies, at least in
theory.

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 Fiscal Policies in the Long Run

◦ Tax simplification and compliance: There is an argument that a simple tax system is easy to
levy.

◦ This also promotes tax compliance and minimizes cost of monitoring tax evasion.

Lecture 10 Fiscal Policies in the Long Run 35 / 36

 Tax Reforms in the long run

Most economists agree that there are supply side effects of tax reforms, but the magnitude of these effects is debated because its
hard to estimate these effects. For example, some economists argue that the increase in the quantity of labour supplied following a
tax cut will be limited because many people work a number of hours set by their employers and lack the opportunity to work
additional hours. Focusing on the impact of tax cuts on aggregate demand, while ignoring any impact on aggregate supply, yields
accurate forecasts of future movements in real GDP and the price level,which indicates that the supply-side effects must be small.

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