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?
Fiscal policy is a government adjustment, which is implemented in order to adjust the spending level and the tax rates. This helps in monitoring and influencing the nation’s money supply (Hansen 2013). Fiscal policy is based on the theories of Keynes, which helps in guiding the actions of the government thereby, taking proactive roles in managing various macroeconomic factors prevailing in the economy. With the help of the fiscal policy, the government aims at regulating the rates of unemployment, inflation rate as well as stabilizing business cycles. Fiscal policy thereby states that the government can thereby influence the level of macroeconomic productivity of an economy by raising or reducing the level of taxes and public expenditures (Mertens and Ravn 2014).
Fiscal policy is associated with various uses in the modern world. One of the most vital uses of fiscal policy is that it increases the savings in an economy. Fiscal policy is used to raise the rate of savings in the economy (Aghion, Hemous and Kharroubi 2014). In the developing countries, the rich class of the society depends on money for their luxuries. The government can impose various taxes on these people thereby providing them with the necessities of life. This would thereby raise the savings in the economy. With the rise in the savings within the country, fiscal policy would also be helpful in encouraging investment by providing them with the incentive of tax holidays in various sectors of the economy. Fiscal policy is considered as an important tool to be used for the achievement of equal distribution of wealth in an economy (Corsetti et al. 2013). With the equal distribution of wealth in an economy, there would be equality among the various classes. Fiscal policy is also used as a vital tool for controlling inflation in the economy. It helps in attaining maximum welfare on the economy thereby improving the quality of life of the people. Fiscal policy aims at raising the productivity and employment opportunity without inflation. Thereby, the countries consider fiscal policy thereby helping the economy to achieve their stability. Deflationary gap is also referred to as recessionary gap in economics, which states the situation where there is an insufficiency in the demand for goods and services in the economy (Auerbach and Gorodnichenko 2013). Equilibrium in such a situation occurs at the lower level of the fill employment level and towards its left.
Figure 1 : Deflationary Gap And Fiscal Policy
(Source: As Created By Author)
In figure 1, the national income will be measured on the x-axis and the aggregate expenditure on the y-axis. It is seen that initially the expenditure curve intersects the aggregate output/production line at point e1, towards the left f the potential line. Thereby it could be stated that the equilibrium income level y1 is below the potential income of y2. Hence, this gap could be stated as the deflationary gap. In order to overcome such discrepancies in the society, the government increase the expenditures thereby stimulating the economy. This shifts the aggregate expenditure curves from ae1 to ae2. Therefore, there is a resultant increase taken together income reaching the fill employment level. This is known as expansionary fiscal policy and it helps to overcome the recessionary gap in the economy.
The government stays committed to returning the budget to a sustainable surplus as soon as possible. Continued discipline to counterbalance new expenditure as well as pass existing budget repair measures is required to combine the budget and to lower government debt (Céspedes and Velasco 2014). The softer domestic prices as well as growth of wages are likely to affect the government receipts. The payment of government as a share of GDP has reduced since the year 2016 from 25.8 percent of GDP to 25.2 percent of GDP in 2016-2017. Real expansion over the forwarded estimates is 1.9 percent that is steady with the 2016-2017 budgets. The program precise variation leads to reduction in payments. The total deficit is anticipated to lower from $36.5 billion in 2016-2017 to $10 billion in 2019-2020. However, the fundamental cash is expected to maintain an enhancing trajectory over the forwarded estimates. The government stays committed to more than offsetting all decision related to new strategies and has thus made decisions that are likely to enhance the fundamental cash balance over the forwarded estimates by $2.5 billion.
In order to affect the economy, the uses of government are referred by fiscal policies. This includes government spending and levied taxes. When the government increases its spending and lowers the taxes, it is said to be expansionary effect. Conversely, the contractionary policy of the government would be considered when the spending decreases and taxes rises. Expansionary policy is related to higher the deficit of the budget and contractionary policy reduces the deficit. In the present situation of Australian economy, where budget deficit prevails, it would be wise for the government to impose contractionary policy in the economy.
The fiscal policy of Australia is mostly based on medium-term structure that is designed to ensure budget balance over the cycle (Blanchard and Leigh 2013). For example, the fiscal policy predicts that fiscal expansion will produce higher rates of interest that will in turn diminish investment spending. Australia reported a deficit of 2.6 percent as a share of total GDP and a structurally adjusted deficit as a share of potential GDP. As compared to other OECD countries, Australia was not relentlessly affected by the worldwide economic crisis. The budget deficit of Australia in the year 2016 was -2.1 percent of GDP whereas; the budget deficit of Belgium was -2.7 percent of GDP and Canada was -2.5 percent of GDP (Abs.gov.au. 2017).
According to the MYEFO statement, it could be stated that the factors that have led an impression on the situation of budget deficit in Australia has been the cut in government spending (ABC News. 2017). There have been more offsets for the government with respect to additional savings in the economy; the government had adopted a cut in the government spending. There has been a considerable rise in the tax that might be taken as a possibility for budget deficits in the economy. Both rise in tax and fall in government spending indicates a deteriorating effect on the budget of the country (Maddison and Denniss 2013). Yet, the effect of increase in tax is also dependent upon the time factor.
Reduction in government spending has a noteworthy effect on the aggregate demand and supply of the country. Earlier, the government had projected the plan for balancing the economy from deficit to surplus in the year 2019-20. Yet, there has been a revision in the target plan of the economy. The department of immigration and broader protection is considered as one of the champion out of MYEFO that gained more than $1 billion in added financial support over four years. An additional $342.2 million has been allocated over two years for relocation arrangements of refugees for protection seekers in offshore centres. A total of $52.5 million is being cut from funding of arts whereas; green army projects are to be restricted at 500 per year thus saving up to $317.5 million from the program.
The effect of government spending mostly affects the aggregate demand structure of an economy. There is a negative impact of the cu in the government spending which can be explained by the help of the figure below:
Figure 2: Effect Of Government Spending Cut On Aggregate Demand
(Source: As Created By Author)
In figure 2, it could be seen that with the fall in the government spending, there is a shift of the aggregate demand curve from AD1 to AD2. With shift of the AD curve towards the left, there has been a considerable fall in the GDP of the country from y1 to y2 and a fall in the price level from p1 to p2. Along with the reduction in aggregate demand, the associated effect of reduced government spending can be stated as the reduction in government borrowing of an economy. The cut in government spending leads to a contraction of the economy, which further restricts the enhancement of the finances in the country. Reduction in spending related to lower tax proceeds followed by higher expenditure on benefits.
Inflation rate- The consumer price inflation of Australia is quite low which throws light on the low rate of wage growth. It highlights other factors like high competitive relation among the retailers, lesser rate of raise in rents and low imports along with the price of the petrol in the economy. There is also a passive inflationary environment globally. There is an expectation with regards to the consumer prices that might grow by 1¾ per cent through the year to the June quarter 2017, before picking up to 2 per cent through the year to the June quarter 2018. This is lower than forecast at the 2016 PEFO (Abs.gov.au. 2017).
Unemployment rate- There has been a downfall of the unemployment rate since its recent peak of 6.3 per cent in July 2015. The unemployment rate is forecast to remain around 5½ per cent in the June quarters of 2017 and 2018. Though there has been a notable fall in the rate of unemployment, the underemployment rate had risen. the rise in the rate of underemployment therefore suggests that there are certain space capacities in the economy that stays within the labour market. The forecast for the participation rate has been revised down since the 2016 PEFO and it is expected to be 64½ per cent in the June quarters of 2017 and 2018(Abs.gov.au. 2017).
Government spending cuts- According to the latest economic outlook of 2016/2017 MYEFO, the government has been delivering on its policy for economic development as well as jobs, with the budget maintaining and enhancing trajectory that is consistent with the fiscal strategy of the government (Abs.gov.au. 2017).
After analysing the economic outlook of both 2015-16 and 2016-17, it could be said that there are several factors that have led to the severity of deficit for 2017. This had lead to the deterioration in the current account. One of factors that have led to budget deficit is competitiveness. The depreciation in exchange rates makes the currency more competitive. The inquisitive thing that is related to broadening of debt and deficit is that it has taken place due to increase in government expenditure along with shortfall in proceeds. Government expenditure as a share of GDP under the Morrison MYEFO forecasts is anticipated to be 25.2 percent of GDP in both 2016-2017.
The vital strengths of fiscal policy is associated with the promotion of macroeconomic stability, which stabilises the economy by supporting the aggregate demand and the private sector incomes during the times of economic recession. It moderates the action of the economy during the period of string development in the economy (Harvie and Van Hoa 2016). Fiscal policy helps in generating added demand when there is a weak productivity prevailing in the country and it even helps in reducing the financial demand when there is a flourishing financial system of the economy. Fiscal policy can become imperative for such economies, which are considered as a part of the monetary union (Ball 2014). This could be the scenario when nominal rates of interest and the exchange rates are not accustomed to the situations of the single country but rather to that of the nation. During the prevalence of unemployment in the society, a change in the taxation structure would help in influencing a noteworthy effect on the level of national income. Fiscal policy may also become successful while shifting the LRAS curve towards the right that will in turn increase real productivity as well as the rate of inflation (Petty et al. 2015).
Fiscal policy in an economy is subjected to various weaknesses along with their strengths. The existence of an active fiscal policy in an economy instigates augmented vagueness regarding the developmental aspects of the economy. Fiscal policy can be stated as a concern with regards to the difficulties faced by the community with respect to health care and pension facilities (Bech, Gambacorta and Kharroubi 2014). An increase in the expenditure along with a cyclically oriented tax cuts would help in translating higher taxes and lower expenditures. Fiscal policy must be relied upon the automatic stabilizers in the short run. It should bear a medium to long run point of reference. In order to stabilize the economy with the fiscal policy, there is a requirement for more or less tax in bad times; however, there must be a rise in the tax and a fall in the government expenditure during god times of the economy (Fazzari, Morley and Panovska 2015). Fiscal policy also leads to conflicts between objectives. Fiscal policy is designed to accomplish one of the objectives that may leave an adverse impact on the other.
Reference
ABC News. (2017). Treasurer flags cuts as MYEFO adds $2.3b to deficit forecast. [online] Available at: https://www.abc.net.au/news/2015-12-15/budget-deficit-increased-as-myefo-released/7029472 [Accessed 9 Feb. 2017].
Abs.gov.au. (2017). Australian Bureau of Statistics, Australian Government. [online] Available at: https://www.abs.gov.au/ [Accessed 9 Feb. 2017].
Aghion, P., Hemous, D. and Kharroubi, E., 2014. Cyclical fiscal policy, credit constraints, and industry growth. Journal of Monetary Economics, 62, pp.41-58.
Auerbach, A.J. and Gorodnichenko, Y., 2013. Output spillovers from fiscal policy. The American Economic Review, 103(3), pp.141-146.
Ball, L.M., 2014. Long-term damage from the Great Recession in OECD countries (No. w20185). National Bureau of Economic Research.
Bech, M.L., Gambacorta, L. and Kharroubi, E., 2014. Monetary policy in a downturn: are financial crises special?. International Finance, 17(1), pp.99-119.
Blanchard, O.J. and Leigh, D., 2013. Growth forecast errors and fiscal multipliers. The American Economic Review, 103(3), pp.117-120.
Céspedes, L.F. and Velasco, A., 2014. Was this time different?: Fiscal policy in commodity republics. Journal of Development Economics, 106, pp.92-106.
Corsetti, G., Kuester, K., Meier, A. and Müller, G.J., 2013. Sovereign risk, fiscal policy, and macroeconomic stability. The Economic Journal, 123(566), pp.F99-F132.
Fazzari, S.M., Morley, J. and Panovska, I., 2015. State-dependent effects of fiscal policy. Studies in Nonlinear Dynamics & Econometrics, 19(3), pp.285-315.
Hansen, A.H., 2013. Fiscal policy & business cycles. Routledge.
Harvie, C. and Van Hoa, T., 2016. The causes and impact of the Asian financial crisis. Springer.
Maddison, S. and Denniss, R., 2013. An introduction to Australian public policy: theory and practice. Cambridge University Press.
Mertens, K.R. and Ravn, M.O., 2014. Fiscal policy in an expectations-driven liquidity trap. The Review of Economic Studies, p.rdu016.
Petty, J.W., Titman, S., Keown, A.J., Martin, P., Martin, J.D. and Burrow, M., 2015. Financial management: Principles and applications. Pearson Higher Education AU.
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