1. What is fiscal policy? Comment on the role of fiscal policy in a modern economy. Illustrate and explain how fiscal policy may be used to remove a deflationary gap?
2. The long-term trajectory of returning to surplus is being pushed back by another year, until 2020-21. What is the current stance of fiscal policy in Australia?
3. According to the MYEFO statement, what factors have contributed to the deterioration of the budget deficit?
4. Unemployment and government spending cuts for 2017. What factors might have lessened or worsened the severity of deficit for 2017 since the release of 2015-16 MYEFO statement?
5. Discuss the strengths and weaknesses of using fiscal policy to stabilise the economy?
1. Fiscal policy is an important macroeconomic tool in the modern economy. Typically, it pertains to the means by which the governments regulates its level of spending and taxation levels to control the aggregate economy. Often, this policy is used alongside monetary policy to achieve the general economic goals in the country. The government implements contractionary or expansionary fiscal policy tools to regulate the degree of economic activity in the country and create healthy economic growth. In addition, the policies are used to achieve low inflation, increase employment opportunities and stabilize the economy.
By and large, the government uses expansionary fiscal policy to stimulate the aggregate economy. Normally, this is achieved by reducing the level of taxation and introducing tax breaks to individuals and businesses. A reduction in the level of taxation increases the amount of disposable income available for households and firms. In turn, they are able to increase their level of spending, which increases the aggregate demand in the economy. An increase in total demand inspires firms to increase their supply to meet the new demand. Consequently, companies are forced to hire more workers to produce more goods and services for the economy. Thus, the level of unemployment in the country declines.
In addition, the government may increase its level of spending to stimulate the aggregate economy during periods of low economic performance in the economy. By increasing its level of spending, the government increases its demand for goods and services in the economy. In turn, this increases the overall demand, allowing firms to expand and hire more workers. It is worth noting that an increase in economic performance in the economy may also bring about stability to the economy.
Apart from stimulating the economy, the government may use fiscal policy to remove deflationary gaps in the economy. Usually, deflationary gaps in the economy arise as a result of the economy operating below full employment output (Pettinger 2012). As such, it is the difference between the attained output and the potential output level. Normally, this occurs during periods of economic recession in the country. During recessionary periods, the deflationary gap is usually quite large. In turn, this creates high levels of unemployment. In addition, there may be cases of underutilization of resources in the country. For this reason, it is important to remove the deflationary gap in the economy.
There are various causes of deflationary gaps in the economy. First, a fall in the aggregate demand in the economy may give rise to a deflationary gap. In addition, a decline in the level of exports and investments in the country as a result of a global recession may bring about deflationary gaps in the economy. Just like any other macroeconomic conditions, the presence of a deflationary gap in the economy may negatively impact the overall economy. Specifically, it may lead to an increase in the rate of unemployment in the country. Additionally, it may slow down the level of economic growth as well as cause deflation to occur in the economy.
In this regard, the government may implement expansionary fiscal policies to stimulate the economy away from the recessionary period, thereby reducing deflationary gaps. Usually, recessionary periods are characterized by weak aggregate demand for services and goods in the economy (Pettinger 2012). Therefore, the government may act by reducing the tax rates or increasing its level of spending to increase the overall demand in the economy. As mentioned earlier, an increase in demand will encourage suppliers also to increase their supply. In turn, they would hire more workers to produce more goods and services. Subsequently, this reduces the level of joblessness in the economy. The new workers will also purchase goods and services using the income they earn. Hence, this further increases the level of aggregate demand. Over time, the level of economic growth would also increase, thereby removing the deflationary gap.
Graph Showing a Deflationary gap in the Economy
Source: (Pettinger 2012).
2. For years now, the Australian government has been operating on a deficit balance. As at 2015, the level of deficit in the country was perceived to grow faster than most developed economies. A budget deficit often arises when the level of expenditure exceeds the level of revenue and income received by the government. In the September quarter of last year, the economy recorded a deficit of about 11, 358 AUD million (“Australia Current Account” 2017). Notably, this was a decrease from the previous quarter’s 15, 943 AUD million deficit. Last year, the deficit on services and goods dropped by about 36.87 percent (“Australia Current Account” 2017). Likewise, the net primary income deficit in the country contracted by about 23.70 percent (Hutchens 2016). Thus, last year, the economy was operating on a deficit budget.
It is worth noting that the budget deficit has been a constant challenge for the Australian government. On average, the country has had a budget deficit of approximately 5143.72 AUD million between 1959 and 2016 (“Australia Current Account” 2017). Markedly, during this period, the highest deficit was recorded in 2015 at 23,014 AUD million (“Australia Current Account” 2017). On the other hand, the lowest level of budget deficit in the country was 295 AUD million, recorded in the December quarter of 1972 (“Australia Budget Deficit” 2017). Thus, it is rational to say that the Australian economy has been operating beyond its means for decades.
Initially, the Australian government had proposed to bring the country’s budget to a surplus by 2019-20. Unfortunately, this trajectory has been postponed to 2020-21 as the country’s fiscal position does not allow for a budget surplus before this period (Woodley & Anderson 2015). Therefore, until then, the economy will continue to operate in a deficit.
Source: (Trading Economic 2017).
It is imperative to note that although the Australian economy has been operating at a deficit for decades, it has one of the lowest budget deficits. As such, compared to other OECD economies, the Australian budget deficit is relatively small (Phillips 2014). The nation’s budget balance reduced significantly by about 4.4 percent, thereby enabling it to reduce the overall level of current account deficits (Collins 2014). As a result, the country has been operating in the middle of OECD pack (OECD 2016). Thus, even though the economy’s budget balance is not sufficient, it is much better than other economies of the OECD.
Structural budget balances between OECD countries
Source: (OECD 2016).
For the long term trajectory of returning the budget to surplus by 2020-21 to be achieved, the government has to undertake various measures. First, the government has to promote economic growth in the country. Primarily, this is because an increase in economic growth in the country will lead to higher employment opportunities and increased government revenues (Labonte 2012). An increase in government revenue will go a long way in reducing the level of budget deficit as more funds would be available to offset the negative balances. Subsequently, this would work towards a surplus budget.
In addition, the Australian government may increase the level of taxation in the country to reduce the fiscal deficit. Notably, an increase in the level of corporate tax, personal income tax, and Value Added Tax will increase the total level of government revenue (Harrison 2016). In turn, the additional revenue can be used to offset the deficit balances on the economy’s budget. In the same way, the government may cut down on its spending on non-essential public projects. By so doing, it would spare a lot of money that would then be used for other productive purposes in the economy. This way, the economy may achieve a surplus budget.
3. The MYEFO report indicates that the Australian government has experienced deteriorations in the level of budget deficits. According to the report, several factors in the economy have brought about the changes in the economy. Also, the government intends to instigate various changes in the level of spending with the aim of reducing the economy’s deficit (Payne & Hall 2014). The government expects to make savings despite the fact that it had incurred extra spending in innovation packages, resettlement of refugees, road funding and pharmaceutical subsidies. As such, the government has offset the additional spending from the new savings measures that have been put in place.
The government plans to save massively on various projects. First, the government purposes to save about $2 billion dollars over a four year period from individuals who falsely claim for welfare payments. Additionally, it targets to save about $650 million in four years from changes in the bulk billing incentives (Woodley & Anderson, 2015). Specifically, it intends to remove bulk billing incentives for MRI and pathology services. Further, the Australian government will save approximately $595 million from health workforce programs over a four-year period (Woodley & Anderson, 2015). Notably, the success of these changes will enable the government to save a lot of money, which in turn will reduce the level of budget deficit in the economy.
It is also worth noting that the government intends to save more money from aged care services and child care subsidies. Over a three-year period, the government expects to achieve a better alignment for funding demanded by care givers with the level of care offered. In turn, this would save the country about $472 million. What is more, Child Care Subsidies will be reduced for households that earn more than $250, 000 (Woodley & Anderson, 2015). Consequently, the government will save about $441 million in a period of 4 years (Woodley & Anderson, 2015). Over time, the success of the proposed spending changes would offset the country’s current account balance into a surplus.
Even so, various consequences may arise in the economy as a result of the changes in government spending. It is worth pointing out that a decrease in government spending is a contractionary fiscal policy. As a result, it may lead to a reduction in the level of activity in the aggregate economy. Hence, this may bring about significant declines in the level of aggregate demand. A fall in the aggregate demand will reduce firm productivity, which may lead to the firing of some employees. Thus, unemployment in the country will rise. In extreme cases, the economy may enter into a recession. For this reason, it is worth to point out the fact that although cutbacks in government expenditure may bring about reductions in government deficits, the policy may result in further macroeconomic problems for the economy. Thus, this instrument should be implemented with modesty.
4. Generally, the level of economic growth in the country is expected to increase in the near future. The 2016-17 MYEFO statement reports that the Australian economy is going through the later stages of the mining boom. The level of GDP is expected to expand by approximately 2 percent. Likewise, the report predicts that the rate of economic growth in the country will increase by about 0.75 percent in the 2017-18 financial year (Australian Government, 2017). Further, the level of cash shortfalls in the country is expected to fall between 2016-17 and 2019-20 by about $10 billion (Australian Government, 2017). One can attribute these improvements to increases in the level of exports and household consumption in the country
Regardless, the level of inflation in the country is predicted to increase over time. For instance, between 2015-16 and 2016-17, the degree of consumer price index is expected to increase by about 0.75 percent (Australian Government,”2017). Further, this indicator may rise by approximately 2 percent in the following year (“Australian Government,”2017). In addition to an increase in the consumer price index, the wage price index is also expected to upsurge during this period. Specifically, the wage price index is predicted to rise by about 2.1 percent between 2015 and 2017 (“Australian Government,”2017). After that, the level of inflation in the country is expected to rise further.
The level of unemployment in the country remains significantly high. However, projections indicate that there are prospects for improvement in the economy that would result in the reduction of joblessness in the country. In 2015-16 the level of unemployment in the country was recorded at 5.7 percent (“Australian Government,”2017). However, predictions indicate that this rate is expected to drop to about 5.5 percent in 2016-17 (“Australian Government,”2017). Afterward, in the following year, this figure is projected to remain constant. By 2018-19, the level of unemployment in the country is expected to decline significantly to about 5.25 percent and remain constant at this level for an extended period of time (“Australian Government,”2017).
In addition, the government intends to use its level of spending as a tool for regulating economic activity in the county. As of now, the government purposes on increasing the level of employment opportunities, economic growth, and stability. Likewise, the Australian government seeks to regulate its level of spending in order to reduce the level of budget deficits in the economy. By and large, this will be achieved through the proposed reductions in funds for the social welfare system. The government expects to reduce the deficit by about $2.1 billion from this change. What is more, the government intends to introduce training loans and vocational education in the country to enhance the employability of the workforce. In turn, this would reduce the government debt by about $25 billion as unemployment benefit payments would be reduced substantially (“Australian Government,”2017). All in all, these changes in government spending would reduce the budget deficit significantly.
5. Fiscal policy is a crucial macroeconomic instrument in the modern economy. Its utilization in Australia has brought about various outcomes for the economy. It is worth noting that the use of the instrument in the contemporary economy is characterized by various strengths and benefits. To begin with, fiscal policies can be used to direct and channel spending to specific projects in the economy. As such, the government can use the policy to fund specific regions, sectors, and projects. They can also stimulate the sectors of the economy where it is perceived to be needed most.
What is more, this policy instrument is effective as it can be implemented within a short period of time, compared to other policy tools. Also, the effects and results of the policy are achieved much quicker than monetary policy instruments (Weil n.d.). Furthermore, fiscal policies can be used to reduce negative externalities in the economy. For instance, the government can set additional taxes for polluting industries to discourage them from polluting the environment beyond ecologically acceptable levels.
Importantly, the policy can be used to narrow the gap between the rich and the poor in the society. Specifically, the government may implement different tax rates for different income groups such that the rich are taxed more than the low-income households (European Central Bank 2005). This way, a greater tax burden is set for the rich while the tax liabilities of the poor are reduced. Additionally, fiscal policies are useful in reducing the level of the country’s debt. For this reason, the instrument is useful in mitigating the effects associated with high public debt.
Even so, the application of fiscal policies in the economy has a number of limitations. For starters, this tool can lead to significant budget deficits if it is not adequately monitored (Kocherlakota 2009). Typically, this arises when the level of government spending is high while the tax rates are low. In turn, this may result in significant debts for the country. On top of that, implementation of the policy may give rise to a conflict of objectives in the economy. A simultaneous mix of expansionary and contractionary fiscal policies in the economy may result in contradictory results in the aggregate economy.
Besides, the use of fiscal policy to solve one problem may lead to the creation of another macroeconomic problem in the economy. For example, increasing the level of government expenditure and reducing taxes in a bid to stimulate aggregate demand and lessen the rate of unemployment may result in an increase in the level of inflation in the economy (Amadeo 2016). Predominantly, this is because an increase in the level of aggregate demand creates pressure in the market, thereby pushing up the general price levels in the economy. All things considered, fiscal policy is a crucial component of the modern economy. Thus, the implementation of this macroeconomic instrument should be combined with other policy tools to achieve the best results for the economy.
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