14 Fiscal Policy Chapter Summary Fiscal policy refers to changes in purchases and taxes by the federal government intended to achieve economic policy objectives, such as high employment, price stability, and high rates of economic growth. Increases in government purchases and reductions in taxes that are intended to increase the level of aggregate demand are called expansionary fiscal policy. Increases in government purchases or decreases in taxes set off a series of increases in consumption spending known as the multiplier effect. As a result of the multiplier effect, expansionary fiscal policy actions have larger effects on aggregate demand than the actual spending or tax changes. Decreases in government purchases and increases in taxes that are intended to decrease the level of aggregate demand are called contractionary fiscal policy. If the government spends more than its tax revenues, there is a budget deficit, and if the governments tax revenues are larger than its spending, there is a budget surplus. When the federal government runs a budget deficit, the Treasury has to borrow funds by selling Treasury securities. The total amount of outstanding Treasury securities is called the federal government debt, also known as the national debt. Additionally, some fiscal policy actions may increase aggregate supply. Learning Objectives When you finish this chapter you should be able to: 1. Define fiscal policy. Fiscal policy is changes in federal taxes and purchases that are intended to affect production, employment, or inflation. The federal governments share of total government expenditures fluctuated significantly during the 1960s, and then trended upwards, peaking at nearly 25% of GDP in 1986. During the 1990s government expenditures declined as a proportion of GDP, with a gradual increase again since 2000. The largest component of federal expenditures is transfer payments (social security and welfare payments). The largest source of federal government revenue is personal income taxes (nearly 50%), followed by company tax revenue (27%). 2. Explain how fiscal policy affects aggregate demand and how the government can use fiscal policy to stabilise the economy. To fight recessions, the federal government can increase government spending or cut taxes. This expansionary policy causes the aggregate demand curve (AD) to shift out more than it otherwise would, raising the level of real GDP and the price level. To fight rising inflation, the government can decrease government spending or raise taxes. This contractionary policy causes the aggregate demand curve to shift out less than it otherwise would, reducing the increase in real GDP and the price level. 3. Explain how the multiplier process works with respect to fiscal policy. Because of the multiplier effect an increase in government purchases or a cut in taxes will have a multiplied effect on equilibrium real GDP. The government purchases multiplier is equal to the change in equilibrium real GDP divided by the change in government purchases. The tax multiplier is equal to the change in equilibrium real GDP divided by the change in taxes. 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. 228 Chapter 14 4. Discuss the difficulties that can arise in implementing fiscal policy. Poorly timed fiscal policy can do more harm than good. Getting the timing right with fiscal policy can be difficult because getting a new fiscal policy approved can be a very long process and because after Parliament approves an increase in spending, it can take months for the spending to actually take place. Because an increase in government purchases may lead to a higher interest rate, it may result in a decline in consumption, investment, and net exports. A decline in private expenditures as a result of an increase in government purchases is called crowding out. Crowding out may cause an expansionary fiscal policy to fail to meet its goal of keeping the economy at potential GDP. 5. Explain how the federal budget can serve as an automatic stabiliser. A budget deficit occurs when the federal governments expenditures are greater than its tax revenues. A budget surplus occurs when the federal governments expenditures are less than its tax revenues. The budget deficit automatically increases during recessions and decreases during expansions. The automatic movements in the federal budget help to stabilise the economy by cushioning the fall in spending during recessions and restraining the increase in spending during expansions. The federal government debt is the value of outstanding bonds issued by the Australian Treasury. The national debt is a problem if interest payments on it require taxes to be raised substantially or other federal expenditures to be cut. However, at the moment the government is act