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ECON1002
Introductory Macroeconomics
Lecture 5: Fiscal Policy
In this lecture, we will study
– How taxes and spending affect the economy
– Balanced budget multiplier
– Fiscal policy and income distribution
– Demographic changes and fiscal policy
– Limitations of fiscal policy
– Australia’s budget and the stance of fiscal policy
– Fiscal policy and government debt
Reading: Textbook Ch 8.
Using a tax cut to close a contractionary gap
Suppose the initial PAE is: PAE = 50 + 0.7Y
What is the equilibrium income? What is the multiplier?
Assume that c = 0.8, current tax rate t = 0.1, and m = 0
What is the new multiplier?
Consider PAE = 50 + 0.7Y. Suppose consumers are pessimistic
and cut their spending by 10 unit,
PAE = 40 + 0.7Y
Setting this planned expenditure equal to GDP implies a new
equilibrium at 133.33 and there now exists a contractionary
output gap. What’s the size of output gap?
Can a tax cut be used to eliminate the output gap?
How much of a tax cut is needed?
Fiscal Policy for Stabilisation
Y
PAE
Y
450
PAE0
133.33 166.67
A fall in exogeneous spending followed by a tax cut
PAE1
PAE2
= + +pPAE C I G
Exogenous Changes and Equilibrium Income
( ) (1 )= − + + + −pPAE C cT I G c t Y
Consider a 3-sector economy (i.e., No X and M and hence m = 0).
1 ( )
1 (1 )
= − + + − −
e pY C cT I G
c t
In terms of changes,
1 ( )
1 (1 )
= − −
∆ ∆ − ∆ + ∆ + ∆e pY C c T I
c
G
t
What happens if government cuts lump sum taxes,
(i.e., cut in the exogenous component of the tax function, )
and purchases ) by the same amount?
Suppose there is an equal change in government purchases
and net taxes, such that, ∆G = ∆T. Govt budget remains
unchanged.
Balanced Budget Multipliers
T
G
The change in the equilibrium income is
Balanced Budget Multipliers
1 ( )
1 (1 )
∆ = − + − −
∆ ∆eY c
c t
T G
Since ∆G = ∆T,
1 ( )
1 (1 )
∆ = − + − −
∆ ∆eY c
c t
G G
1 (1 )
1 (1 )
∆ = − − −
∆
eY c
c
G
t
1
1 (1 )
−
∆ = − −
∆
e GcY
c t
The balanced budget multiplier is
Balanced Budget Multipliers
1
1 (1 )
∆ −
= −∆ −
eY c
c tG
1 ( )
1 (1 )
∆ = ∆ − ∆ + ∆ + ∆ − −
e pY C c T I G
c t
From
We can see 1 ,
1 (1 )
∆
= ≡
− −∆
e
G
Y k
cG t
,
1 (1 )
∆ −
= ≡
− −∆
e
T
Y c k
c tT
Govt spending multiplier
Tax multiplier
Hence, 1
1 (1 )
∆ −
= ≡ = + − − ∆
e
BB G T
Y k
G
c k k
c t
Quiz: What if G and T are both cut by the same amount, $5m?
Exercise: Assume c = 0.8 and t = 0.1.
If G and T both rise by 5, What’s the change in Y?
( )1 0.8(5) (5)
1 0.72
∆ = − + −
eY
( )( )3.57 4 5 3.57∆ = − + =eY
Balanced Budget Multipliers
Y
PAE
Y
450
PAEold
A simultaneous cut in G and T by $5m
(e.g. a baby bonus financed by a cut in G)
PAEnew
The University of Sydney Page 11
In the Keynesian model, fiscal policy affects the demand side (PAE) of the
economy.
But, there are other issues…….
– Fiscal policy can affect the supply side of the economy too
(how?). That is, potential output (y*) can be affected.
– Budget deficits need to be financed somehow. It matters
how budget deficits are financed. S and I can be affected.
A higher government borrowing can ‘crowd out’ private
investment!
– Not always flexible enough for stabilisation (‘inside lag’:
takes time from policy discussion to implementation). May
be inadequate as a short-term stabilisation tool.
Fiscal policy as a stabilisation tool
Fiscal policy is less effective than the above model suggests.
In Australia,
Fiscal policy has medium term objectives.
Government follows balanced budget rule.
But, fiscal policy is still an important stabilising force. Why?
The presence of automatic stabilisers (taxes fall and transfers
rise when GDP falls and vice versa)
Fiscal policy is better suited when there is a prolonged period
of recession (e.g., the Great Depression, the Lost Decade in
Japan, GFC in 2007-8)
Fiscal policy as a stabilisation tool
Fiscal policy has distributional consequences.
Taxation system matters: Progressive, regressive or
flat? GST may improve efficiency but worsens equity.
Demographic changes affect fiscal policy. Ageing
population and low birth rates affect participation
rate and labour force.
Who should pay for the elderly and retired? PAYG
(Pay-as-you-go) or Fully funded pension system?
What is the best retirement income support system?
Australia has The Future Fund