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ECON1002
Introductory Macroeconomics
Week 5 Lecture
School of Economics
Semester 1, 2022
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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.
https://www.westpac.com.au/federal-budget/
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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
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Y
PAE
Y
450
PAE0
133.33 166.67
A fall in exogeneous spending followed by a tax cut
PAE1
PAE2
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= + +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
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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
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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
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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
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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
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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
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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
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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
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 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. See Intergenerational Report
2015 (https://treasury.gov.au/publication/2015-intergenerational-report/) .
 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 (http://www.futurefund.gov.au/), a
sovereign wealth fund.
Contemporary Issues in Fiscal policy
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Managing demographic change
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Fiscal policy and the public debt
Governments have three major ways they can finance their
spending:
1. They can raise taxes. What constrains this?
2. They can borrow (issue securities or debt, e.g.,
government bonds). They have to pay interest r
on the borrowings. What constrains this?
3. They can simply borrow money from the central
bank to finance their spending. What is the issue
with this?
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Benefits of low public debt
 Low levels of public debt are desirable to reduce
crowding out, which occurs where government borrowing
increases interest rates and therefore decreases
investment.
 Borrowing because of deficit budgets can’t be sustained
forever, and eventually surpluses would be required to
reduce debt.
 Intergenerational equity refers to the concept that
the current generation should not impose an unfair
burden on future generations.
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Benefits of having some (non-zero) public debt
 Public debt can also have a net benefit for the
economy, even when allowing for crowding out and
intergenerational equity effects.
 This is when important infrastructure projects are
financed through public debt.
 Such projects have been estimated to add 0.4% p.a. to
productivity for every 1% increase in public spending.
 Having some positive public debt is useful as it
allows bond markets to stay afloat and investment
instruments to households.
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Understanding Australia’s Government Budget
 Budget timeline:
Budget 2021-22 MEYFO 2021-22 Budget 2022-23
May Jan Mar 29
2021 2022 2022
– MYEFO (Mid-Year Economic & Fiscal Outlook) released in January of each year.
Provides an update on economic and budget forecasts.
– 2020-21 Budget delayed until October due to Covid-19.
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Understanding Federal Budget: Big Picture
Prime Minister and Treasurer, Source: The Australian
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Fiscal Balance vs GDP
Source: 2021-22 Budget and PBO analysis.
Underlying cash balance
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Measures of Government Debt
 Gross Debt = Face value of Commonwealth Government Securities on issue
 Net Debt ≈ Gross Debt less (selected) financial asset (all at ‘fair value’).
Allow for the fact that government may hold financial assets.
Note: Net interest payments are equal to total interest payments less interest receipts.
Source: 2019-20, 2020-21 and 2021-22 Budget and PBO analysis.
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The official (announced) measure of the budget deficit is incorrect.
(Why?)
Is it a good measure of the stance of fiscal policy?
The “structural” deficit is often a better measure.
Requires 2 basic adjustments:
1. Inflation adjustments
(i) Fiscal drag: Nominal GDP rises and hence tax collection, exerting
a potentially depressing effect on the economy
(ii) Bracket creep: As nominal income is higher due to inflation, they
are automatically moved into higher tax brackets (see Lecture 2 on
the effects of inflation)
MEASUREMENT OF THE BUDGET DEFICIT
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2. Business cycle (cyclical) adjustment
According to Keynesian models,
Fiscal policy business cycle
Budget deficit
Why?
In recessions tax receipts fall and expenditure on unemployment
benefits rises (automatic stabilisers) so the budget deficit
increases. It does not necessarily reflect any deliberate change
in policy?
MEASUREMENT OF THE BUDGET DEFICIT
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Debt and Deficits:
Dynamics of Government budget constraint
– Let Bt-1 be the stock of securities the government has owing at the
end of the previous period. Any new borrowing in the period t
means that Bt – Bt−1 > 0. This also means the government has to pay
interest on its stock of debt, rBt−1, where r is the real rate of interest.
– Therefore, the spending that needs to be undertaken in the period
by the government, which needs to be financed by some method, is:
Gt + rBt–1 = Tt + (Bt – Bt–1)
Gt = Government expenditure during year t,
Tt = Tax revenue (net of transfer payments) during t.
Bt – Bt−1 = New Borrowing during year t,
rt = Real interest rate during year t,
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 Define budget deficit as
Bt – Bt–1 = rBt–1 + Gt – Tt
 When the government runs a deficit budget, the left-
hand side is positive (why?) and we will be adding to
the stock of public debt, Bt – Bt−1 > 0
 When the government runs a surplus budget, the left-
hand side is negative, and the stock of debt will fall,
Bt – Bt−1 < 0
Dynamics of Government budget constraint
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Bt – Bt-1 = rBt-1 + (Gt – Tt)

Change in debt Interest payments Primary deficit
Government budget constraint
1
1
−
−
−t t
t t
B B
Y Y
= 1
1
( ) −
−
− t
t
Br g
Y
+ −t t
t
G T
Y

Re-arrange it as Bt = (1+r)Bt-1 + (Gt – Tt)
Dividing it through by Yt and re-arranging it, we can write it as
follows.
Change in public debt is now in terms of the ratios of GDP, where g
is the growth rate of GDP.
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Public debt is rising, ceteris paribus, if
(1) Primary surplus is falling.
(2) The real interest rate is rising
N.B. Real interest rate = Nominal interest rate – Inflation
(3) Growth rate of output is falling.
1
1
−
−
−t t
t t
B B
Y Y
= 1
1
( ) −
−
− t
t
Br g
Y
+ −t t
t
G T
Y

Government budget constraint and Public debt
Quiz: What would happen to public debt when inflation is rising, ceteris paribus?