Fiscal Policy — Flashcards & Quiz

Q1: Define fiscal policy and its instruments.

Fiscal policy is the use of government spending (G) and taxation (T) to influence the level of aggregate demand and achieve macroeconomic objectives. It is implemented through the annual federal budget, prepared by the Treasurer. Government spending has a direct and immediate impact on AD because it is a component of the AD equation. Taxation affects AD indirectly — changes in income tax alter household disposable income and thus consumption (C), while changes in company tax affect business profitability and investment (I). Expansionary fiscal policy involves increasing G and/or reducing T to stimulate AD, typically resulting in a budget deficit. Contractionary fiscal policy involves decreasing G and/or increasing T to restrain AD, typically resulting in a budget surplus. Fiscal policy can also be used structurally to shift LRAS through investment in infrastructure, education and health.

Q2: Explain discretionary fiscal policy versus automatic stabilisers.

Discretionary fiscal policy involves deliberate, active decisions by the government to change spending levels or tax rates in response to economic conditions. It requires legislation and has implementation lags (recognition lag, decision lag, implementation lag, impact lag). Automatic stabilisers are built-in features of the tax and welfare system that moderate the business cycle without any deliberate government action. In a downturn: progressive income tax revenue falls automatically as incomes decline (reducing the tax burden), and welfare payments (JobSeeker, Youth Allowance) increase as more people become eligible (boosting transfer payments). Both effects cushion the fall in aggregate demand. In a boom: tax revenue rises automatically as incomes grow, and welfare payments fall as unemployment decreases, both dampening aggregate demand and restraining inflation.

Q3: Explain structural vs cyclical budget balance.

The budget balance can be decomposed into two components. The structural (underlying) balance reflects the government's discretionary policy settings — it is what the balance would be if the economy were operating at its potential output (trend GDP). It reveals whether the government is deliberately running an expansionary or contractionary fiscal stance. The cyclical balance reflects the automatic effects of the business cycle on revenue and spending — during a recession, tax revenue falls and welfare spending rises automatically, worsening the deficit even without any policy change. The actual budget balance is the sum of both: a large deficit during a downturn may be mostly cyclical (automatic) rather than structural (deliberate). Understanding this distinction is critical for assessing whether fiscal policy is genuinely stimulatory or merely reflecting weak economic conditions.

Q4: Strengths and limitations of fiscal policy.

Strengths: 1) Targeted — spending can be directed at specific sectors, regions or demographic groups (e.g. infrastructure in regional WA, First Home Owner Grant for young buyers). 2) Effective at the zero lower bound — when monetary policy is exhausted (rates near zero), fiscal stimulus becomes the primary tool for boosting AD. 3) Direct AD impact — government spending (G) is a component of AD, so increases have an immediate first-round effect. 4) Structural benefits — fiscal policy can address supply-side through infrastructure, education and health investment, shifting LRAS. Limitations: 1) Implementation lags — recognition, decision and implementation lags mean fiscal responses are slow (weeks to months). 2) Political constraints — spending and tax decisions are influenced by electoral cycles and ideology, not just economic conditions. 3) Crowding out — government borrowing can push up interest rates and displace private investment (though less likely in a recession). 4) Rising public debt — sustained deficits increase the debt-to-GDP ratio, raising future interest payments and potentially constraining future policy. 5) Difficult to reverse — spending programs create constituencies that resist cuts, and tax cuts are politically hard to reverse.

Q5: Explain crowding out.

Crowding out occurs when increased government borrowing to finance a budget deficit competes with private borrowers for a limited pool of loanable funds in financial markets, pushing up interest rates. Higher interest rates increase the cost of borrowing for households and businesses, reducing private consumption (C) and investment (I), which partially offsets the expansionary effect of the original government spending increase. The extent of crowding out depends on the state of the economy: near full capacity, when financial markets are tight and private demand for funds is strong, crowding out is significant — government spending displaces private spending rather than increasing total AD. During a recession, when private demand for credit is weak and there is excess capacity in financial markets, crowding out is minimal because government borrowing fills the gap left by reduced private borrowing rather than competing with it.

Q1: Fiscal policy involves the RBA adjusting the cash rate.

Answer: FALSE

That is MONETARY policy. Fiscal = government spending and taxation.

Q2: Expansionary fiscal policy involves increasing spending and/or reducing taxation.

Answer: TRUE

Higher G or lower T stimulates AD, typically creating a deficit.

Q3: Automatic stabilisers require deliberate government decisions.

Answer: FALSE

They operate automatically via progressive taxation and welfare payments.