Chapter 20: Fiscal Policy,
Deficits and Debt
Differentiate between expansionary and contractionary fiscal policy
Fiscal policy consists of: 1. Changes in Government spending
2. Changes in tax collection
The fiscal policy can be defined as discretionary (‘active’)
Discretionary changes in government spending and taxes are at the option of the
government, they do not occur automatically.
Changes that occur without government action are non-discretionary (‘passive’ /
‘automatic’)
Increase in Demand = Demand-Pull inflation
Decrease in Demand = Recession and unemployment
Fiscal policy stimulates economy / rein inflation
Fiscal policy is designed to achieve FULL EMPLOYMENT, encourage ECONOMIC
GROWTH and CONTROL INFLATION.
Expansionary Fiscal Policy: An increase in government purchase of goods and services,
decrease in net taxes or a combination of the two to increase aggregate demand and to
expand real output.
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Used when recession occurs
Economy suffers from recession and cyclical unemployment
If budget is balanced at outset, this policy will create government budget deficit
Government spending in excess of taxes
Increase in government spending:
- Shifts AD curve to the right
- Multiplier effect magnifies
initial change in spending into
successive rounds of new
consumption spending
- Unemployment falls
Figure to the right shows this
Tax reduction:
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Reduction in taxes shifts AD curve to the left
Increase in disposable income increases aggregate demand
Multiplier effect causes successive rounds of increased consumption
Part of tax reduction increases savings this shifts AD curve but not as far as
government spending
- The smaller the MPC, the greater tax cut is needed to shift the AD curve
Combination of tax reduction and government spending
- This will produce the desired initial decrease in spending
- Will eventually increase AD
- Increases GDP
Contradictory Fiscal Policy: A decrease in government purchases of goods and
services, an increase in net taxes, or some combination of the two to decrease aggregate
demand which therefore controls inflation
- When demand-pull inflation occurs, contractionary fiscal policy may help control
it.
- Government can decrease government spending, raise taxes or combination
of the two.
- In case of demand-pull inflation, fiscal policy should cause government budget
surplus.
- Tax revenues in excess of government spending.
Decreased government spending
- Reduced government spending shifts AD curve to the left to curb demand-pull
inflation.
- Multiplier effect causes AD curve to shift even further to the left
- Thus, deflation will occur.
- Economy is not as simple – increases in demand causes prices to rise but a
decrease in demand doesn’t drop prices.
- Stopping inflation is a matter of halting the rise of prices, not bringing it down.
- Contractional fiscal policy stops continuous right shift of AD curve.
Increased taxes
- Tax increases reduces
consumption spending
- AD curve shifts to the left
- Thus, multiplier effect shifts
further left
Combination of the two
- Reduces AD and checks inflation
Budget deficit: the amount by which the expenditures of the government exceed its
revenues in a year
Budget surplus: the amount by which government revenue exceeds its expenditures in
a year
Policy options: Government spending or taxes?
Built-In Stability
 Government tax revenues change automatically over the course of a business
cycle and in ways stabilize the economy.
 This built-in stability constitutes nondiscretionary budgetary policy and results
from make-up of most tax systems.
 Net Tax revenues vary directly with GDP.
 Virtually any tax will yield more tax revenue as GDP rises.
Built-in stabilizer: a mechanism that 1. increases government budget deficit (or
reduces its surplus) during a recession, 2. increases government budget surplus (or
reduces its deficit) during an expansion without any action by policy makers.
e.g. the tax system
Economic importance
The economic importance of direct relationship between tax receipts and GDP becomes
apparent when we consider
1. Taxes reduce spending and AD
2. Reductions in spending are desirable when economy is moving towards inflation
3. Increases in spending is desirable when economy is slumping
Tax progressivity
 Built-in stability depends on responsiveness of tax revenues to changes in GDP
 The more progressive the tax system, the greater the built-in stability
 Built-in stabilizers can only diminish, not eliminate swings in real GDP
-Line T represents the direct relationship
between tax revenues and GDP.
-The steepness of T depends on the tax
system itself
-If tax revenue changes sharply when
GDP changes, T will be steep with vertical
distances between T and G (the deficits
and surpluses) will be large
-If tax revenue hardly change when GDP
changes; the slope will be gentle
Most built in stability: higher the gradient
Least built in stability: lower the gradient (flatter the line)
Less built in stability (lower the line) = the largest generated cyclical deficits
Progressive Tax: The average tax rate rises with GDP
Average tax rate increases as taxpayer’s income increases
Decreases with a decrease in taxpayer’s income
Proportional Tax: Average tax rate remains constant as taxpayer’s income changes or
when GDP rises.
Regressive Tax: Average tax rate falls as GDP rises
Tax whose average tax rate decreases as taxpayer’s income increases and increases
when taxpayer’s income decreases.
Evaluating Fiscal Policy
In evaluating the status of the fiscal policy, we must adjust deficits and surpluses to
eliminate automatic changes in tax revenues.
Then compare the sizes of the adjusted budget deficits or surpluses to the levels of
potential GDP.
Standardised budget: AKA: Full-employment budget
A comparison of government expenditures and tax collections that would occur if the
economy operated at full employment (the full-employment budget)
Standardised budget is used to adjust the actual budget deficits and surpluses to
eliminate automatic changes in tax revenues.
Standardized budget measures what budget deficit or surplus would be with existing
tax rates and government spending levels if the economy has full employment
level of GDP.
Compares actual government spending with tax revenues that would have occurred if
economy had achieved full-employment GDP.
Cyclical deficit: a government budget deficit is caused by a recession and the
consequent decline in tax revenues.
-A recession occurs and GDP1 falls to GDP2
-Assume government takes no discretionary
action so lines G and T stay the same.
-Tax revenues automatically fall to R450
(point c) at GDP2
-While government spending remains at
R500 (point b)
-A R50 budget deficit (distance bc) arises
-But this cyclical deficit is a by-product of
the economy’s slide into recession
- Real output declined from full employment
(GDP3 to GDP4) and govt. response was
reduced tax rates in year 4.
-Represented by downward shift of T1 to T2
- Govt. spending in year 4 is R500 (point e)
-The R25 tax revenue where e exceeds h is
the standardised budget deficit that
increased from 0 in year 3 (before tax cut) to
a positive percentage (R25 x GDP3)
This increase reveals that the fiscal policy is
expansionary
Problems, criticisms and complications
Problems of timing
Recognition lag: Time between beginning of recession and inflation and certain
awareness that it is actually happening. Arises because of difficulty in predicting future.
Administrative lag: Typically, a lag between time the need for action is realized and
action is actually taken.
Operational lag: A lag between the time fiscal action is taken and the time that action
affects output, employment and price level.
Political considerations
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Fiscal policy is conducted in political arena.
Politicians may rationalize actions and policies in their own self-interest.
May use expansionary fiscal policy before election and contractionary after.
Causing political business cycles.
Political business cycles: tendency of parliament to destabilise the economy by
reducing taxes and increasing government expenditures before elections and to raise
taxes and lower expenditures after elections.
Public debt
Public debt: total amount owed by the government to the owners of government
securities which is equal to the sum of past government budget deficits less
government budget surpluses.
Emerged mainly because of expansionary fiscal policy objectives.
Primary burden of the debt = Interest charge accruing on bonds sold to finance debt.
False concerns:
- Large public debt won’t bankrupt the government because of Refinancing and
Taxation.
- Public debt is easily refinanced by selling new bonds.
- Government can levy and collect taxes to finance debt
Substantive issues:
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Income distribution: distribution of ownership of government securities very uneven
Incentives: Higher tax may dampen incentive to bear risk, innovate and risk
Foreign owned public debt
Crowding-out effect
Practical Applications
1.1 Refer to the above diagram. The economy is at equilibrium at point A. What fiscal policy would be most
appropriate to control demand-pull infla3on?
A) decrease aggregate demand by increasing taxes
B) increase aggregate demand by decreasing taxes
C) decrease aggregate supply by increasing taxes
D) increase aggregate demand by increasing government spending
1.2 Refer to the above diagram. The economy is at equilibrium at point B. What fiscal policy would increase
real GDP?
A) increase aggregate demand from AD2 to AD1 by decreasing taxes
B) decrease aggregate demand from AD2 to AD3 by increasing government spending
C) decrease aggregate demand from AD2 to AD3 by decreasing government spending
D) increase aggregate demand from AD2 to AD3 by decreasing taxes
1.3 Refer to the above diagram. The economy is at equilibrium at point C. What fiscal policy would increase
real GDP?
A) increase aggregate demand from AD2 to AD1 by decreasing taxes
B) decrease aggregate demand from AD2 to AD3 by increasing taxes
C) increase aggregate demand from AD1 to AD2 by increasing government spending
D) make no change because the economy is at or near its full-employment level of real output
1.4 Refer to the above diagram. An expansionary fiscal policy can best be represented by a:
A) shift in the aggregate demand curve from AD2 to AD1.
B) shift in the aggregate demand curve from AD3 to AD2.
C) shift in the aggregate demand curve from AD1 to AD2.
D) movement along the aggregate demand curve.
1.5 Refer to the above diagram. A contrac3onary fiscal policy can best be represented by a:
A) shift in the aggregate demand curve from AD1 to AD2.
B) shift in the aggregate demand curve from AD3 to AD2.
C) shift in the aggregate demand curve from AD1 to AD3.
D) movement along the aggregate demand curve
2.1) Refer to the above diagram. Which tax system has the most built-in stability? A) T4 B) T3 C) T2 D)
T1Answer: D
2.2) Refer to the above diagram. Which tax system has the least built-in stability? A) T4 B) T3 C) T2 D)
T1Answer: A
2.3) Refer to the above diagram. Which tax system will generate the largest cyclical deficits? A) T4 B) T3 C)
T2 D) T1
Answer: D
3.1) If the full-employment GDP for the above economy is at L, the: A) actual budget will have a deficit. B)
standardized budget will have a deficit. C) actual budget will have a surplus. D) standardized budget will
have a surplus. Answer: D
3.2) With the expenditures programs and the tax system shown in the above diagram: A) the public budget
will be expansionary at all GDP levels above K, and contrac3onary at all GDP levels below K. B) the public
budget will be a destabilizing force at all levels of GDP. C) deficits will occur at income levels below K, and
surpluses above K. D) deficits will occur at income levels below H, and surpluses above H. Answer: C
3.3) Refer to the above diagram. The degree of built-in stability in the above economy could be increased
by: A) reducing government purchases so that the purchases line shifts downward but parallel to its present
position. B) changing the tax system so that the tax line is shifted downward but parallel to its present
position. C) changing the tax system so that the tax line has a greater slope. D) altering the government
expenditures line so that it has a posi3ve slope. Answer: C
4)The following is budget informa3on for a hypothe3cal economy. All data are in billions of rand.
4.1 In which year is there a budget surplus? A) Year 1 B) Year 2 C) Year 3 D) Year 4 Answer: B
4.2 In which year is there a balanced budget? A) Year 1 B) Year 2 C) Year 3 D) Year 4 Answer: C
4.3 What is the public debt as a percentage of GDP in Year 5? A) 1.6 percent B) 2.7 percent C) 4.9 percent
D) 6.7 percent Answer: B
Calculate Public Debt:
4.4 What year is the budget deficit R250 billion? A) Year 2 B) Year 3 C) Year 4 D) Year 5 Answer: D
4.5 Assume that Year 1 is the first year for this economy and Year 5 is the current year. What is the public
debt in this economy? A) R100 billion B) R150 billion C) R250 billion D) R300 billion
Answer: D
5.1 Using the Id1 schedule, assume that the government needs to finance the public debt and this public
borrowing increases the interest rate from 3% to 4%. How much crowding out of private investment will
occur? A) R100 billion B) R200 billion C) R600 billion D) R700 billion
Answer: A
5.2 Assume that the public debt is used to improve the capital stock of the economy and that, as a
consequence, the investment-demand schedule changes from Id1 to Id2. At the same 3me, the interest
rate rises from 3% to 4% as the government borrows money to finance the public debt. How much crowding
out of private investment will occur in this case? A) R0 B) R100 billion C) R600 billion D) R700 billion
Answer: A
5.3 The crowding-out effect means that: A) higher interest rates would decrease private investment
spending. B) lower interest rates would increase private investment spending. C) lower interest rates would
decrease private investment spending. D) higher interest rates would increase private investment spending.
Answer: A