Fiscal Policy

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This is an article from Macroeconomics. To get back to the list of all topics click here.

[1]Fiscal policy is a direct continuation from the AE Model where changing the amount of government spending and transfer payments are seen as tools to stabilise the economy and bring it back to equilibrium. This article discusses these policies and explores their other uses in the economy.


Textbook Readings

Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011), pp. 164 - 187 (Chapter 6).

Government Spending, Transfer Payments and Planned Spending

[2]Continuing from the AE model which concluded that governments can reduce output gaps by intervening, we note that the equation for equilibrium GDP is dependent on both government spending and transfer payments (both of which are controlled by the government). Fiscal policy therefore involves decisions about how much governments should spend and how much taxes to collect.

Government Spending

[3]Increasing government spending has the effect of pushing the PAE line upwards, meeting the 45° line at a higher point, and hence pushing towards a higher potential output. The result is that increased government expenditure should be used to reduce a contractionary gap. The inverse of this is that reducing government spending drops the PAE line, pushing downwards towards potential output. That is, reducing government expenditure works to reduce an expansionary gap.

Transfer Payments

[4]Unlike government spending, decisions about transfer payments and taxes don't affect PAE directly, but are rather indirectly involved through affecting the disposable income of households. The theory is that if disposable income (Y-T) is higher, then overall spending will increase. The model suggests that tax cut backs don't shift the PAE curve upwards or downwards, it simply makes it steeper. By doing so, PAE cuts the 45° line at a higher point and should therefore be used to reduce a contractionary gap. Again, the converse is true- increasing taxes makes the PAE line shallower and should therefore be used to reduce an expansionary gap.

Fiscal Policy Qualifications

[5]The reality is that while changing government expenditure or transfer payments levels affect PAE, it also affects potential output. The result is that predicting the affect on the economy through fiscal policy is not always straight forward. The reason potential output is affected is that if the government spends more on roads (for example), then firms can use those roads to better deliver goods and services, by extension increasing output.

[6]A second very important qualification involves the budget deficit. Fiscal policy may call for increased government spending but if that causes the government to spend more than it is gaining in revenue then a budget deficit occurs. Sustained budget deficits can cause investment and spending to reduce in the long run, stunting the economy.

[7]A third qualification is that fiscal policy is not necessarily easy to implement. We may think that increasing government expenditure or increasing taxes is an easy move but remember that the whole idea of fiscal policy is to reduce output gaps, which occur in the short run. The reality is that increasing taxes might take months to implement since it must be passed by parliament and run through the bureaucracy, which may make implementation too late.

Having said this though, economists note that the economy has automatic stabilisers. These are the effects of output fluctuations on transfer payments and taxes without any government policy implementation. The reality is that if income drops in households, then they pay less taxes and the government tends to pay more transfer payments, in effect stabilising the economy anyway. In addition, fiscal policy can be used to overcome sustained recessions.

Other Roles of Fiscal Policy

[8]In reality, fiscal policy is not just used to stabilise the economy, but is used for other purposes as well. Three of these are discussed here.

Distribution of Income

[9]Since the government can choose to change its tax rates, it inadvertently affect disposable income. However the affect is not the same on all households: under curent policy in Australia, taxes are taken at different rates depending on individual income. The effect is that income distribution is relatively equal (or at least more equal than without this policy).

Managing Demographic Change

[10]Fiscal policy is also used to determine government expenditure in the future. Many governments today are aware of the increased average age of their populations as longevity increases and birth rates decrease. The effect of this is that governments will have to spend much more in the future on healthcare and transfer payments in the future. As a result, running into deficits now are seen by many as adverse as it will hinder an essential spending component in the future.

Public Debt

[11]Another use for fiscal policy is in trying to reduce public debt. The reason for reducing public debt has already been discussed here, but in addition to those reasons there is also the desire to reduce crowding out (the effect deficits have on real interest is increasing them, thereby reducing investments). To understand how reducing deficits might work by using fiscal policy, we consider government expenditure and revenue streams. Expenditure consists of usual spending (G), of transfer payments (Q) and any interest payable for previous borrowings (rBt-1. Revenue streams on the other hand consist of taxes raised (T), previous borrowings (Bt-1 and new borrowings (Bt). Then an equation can be set up as:

G + Q + rBt-1 = T + (Bt - Bt-1)

Where (Bt - Bt-1) represents the overall amount the government owes in a period.

Now the equation can be rearranged to yield

G + Q + rBt-1 - T = (Bt - Bt-1)

Where the left hand side is the governments expenditure and the right hand side is the government debt.

Now if the government requires more spending and transfer payments, or decreasing taxes, then the left hand side increases, implying that the government debt increases as well, and the converse is also true. The result is that over time, running a surplus that can pay off any interest payments will over time also reduce the amount of debt owed by the government.


"Textbook" refers to Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011).

  1. Textbook p. 166
  2. Tetbook p. 166
  3. Textbook p. 166
  4. Textbook p. 171
  5. Textbook p. 174
  6. Textbook p. 175
  7. Textbook p. 176
  8. Textbook p. 177
  9. Textbook p. 177
  10. Textbook p. 180
  11. Textbook p. 184
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