Effectiveness of Fiscal Policy

Effectiveness of Fiscal Policy in Australia

1. Effectiveness of fiscal policy WACE Economics - Unit 13 Video 1 (c) Andrew Tibbitt 2017 1

2. Overview of problems Crowding out: Extra government spending can lead to falls in other components of aggregate demand Time lags: It takes time to change fiscal policy and for these changes to have an impact on the economy Politicians’ expansionary bias: Politically it may be difficult to wind back government spending after a period of higher spending Legacy of debt: Government borrowing leads to government debt and imposes a servicing and repayment burden on future generations Economy’s capacity for self-adjustment: Neo-classical economists believe that economies will adjust automatically towards a long-run equilibrium at the level of long-run aggregate supply without the need for an additional fiscal stimulus (c) Andrew Tibbitt 2017 2

3. Problem 1: Crowding out (c) Andrew Tibbitt 2017 3 AD = C + Ip + G + (X – M) Expansionary fiscal policy involving increased net government spending may lead to reduced levels of consumption spending, planned investment and net exports and an overall fall in aggregate demand AD = C + Ip + G + (X – M)

4. Problem 1: Crowding out (c) Andrew Tibbitt 2017 4 AD = C + Ip + G + (X – M) Expansionary fiscal policy involving increased net government spending may lead to reduced levels of consumption spending, planned investment and net exports and an overall fall in aggregate demand AD = C + Ip + G + (X – M)

5. Three types of crowding out Resource crowding out: Caused when new or additional government projects replace spending that the private sector would have done anyway or use resources that could have been used more efficiently in the private sector. (c) Andrew Tibbitt 2017 5

6. Three types of crowding out Resource crowding out: Caused when new or additional government projects replace spending that the private sector would have done anyway or use resources that could have been used more efficiently in the private sector. Financial crowding out: Fiscal stimulus leads to extra borrowing and higher interest rates which cause a fall in planned investment and consumption. (c) Andrew Tibbitt 2017 6

7. Three types of crowding out Resource crowding out: Caused when new or additional government projects replace spending that the private sector would have done anyway or use resources that could have been used more efficiently in the private sector. Financial crowding out: Fiscal stimulus leads to extra borrowing and higher interest rates which cause a fall in planned investment and consumption. Exchange rate crowding out: Higher interest rates cause an appreciation of the exchange rate, a reduction in international competitiveness and a fall in net exports. (c) Andrew Tibbitt 2017 7

8. Resource crowding out Government spending projects may: Replace spending that would otherwise have taken place in the private sector (e.g. roll out of broadband, development of Perth’s river front) Use resources that could have been used more efficiently in the private sector (e.g. construction workers) Government spending projects need to be carefully targeted to avoid these issues e.g. using unemployed resources to deal with situations of market failure. (c) Andrew Tibbitt 2017 8

9. Financial crowding out (c) Andrew Tibbitt 2017 9 Fiscal stimulus increases borrowing and leads to rise in interest rates. Rise in interest rates reduces investment and consumption AD does not rise as much as expected

10. Diagramatic representation of financial crowding out (c) Andrew Tibbitt 2017 10 Rise in demand for loans leads to rise in interest rates

11. Diagramatic representation of financial crowding out (c) Andrew Tibbitt 2017 11 Rise in demand for loans leads to rise in interest rates Rise in interest rates leads to fall in planned investment

12. Diagramatic representation of financial crowding out (c) Andrew Tibbitt 2017 12 Rise in demand for loans leads to rise in interest rates Rise in interest rates leads to fall in planned investment Fall in planned investment offsets impact of fiscal stimulus on aggregate demand

13. Evaluation of financial crowding out With globalisation of financial markets a rise in demand for funds may be balanced by a rise in money supply – hence interest rates may not rise. Investment demand may be relatively insensitive (price inelastic) to changes in interest rates BUT 3. Business may see a growing budget deficit as a sign of poor government financial management and this may affect their confidence to undertake new investment. (c) Andrew Tibbitt 2017 13

14. Exchange rate crowding out (c) Andrew Tibbitt 2017 14 Deficits and debt may cause interest rates to rise. A rise in interest rates may lead to a rise in the rate of exchange Exporters and local firms competing with imports become less competitive and the value of net exports falls

15. Exchange rate crowding out (c) Andrew Tibbitt 2017 15 Deficits and debt may cause interest rates to rise. A rise in interest rates may lead to a rise in the rate of exchange Exporters and local firms competing with imports become less competitive and the value of net exports falls Evaluation: Factors other domestic interest rates affect exchange rates (e.g. interest rates overseas, strength of the economy, credit ratings, level of risk in global economy) Non-price factors (e.g. productivity, design, quality, delivery) affect international competitiveness

16. Crowding-in If crowding out occurs, might it also happen in reverse? Would tightening fiscal policy (reducing budget deficits in a program of austerity) actually stimulate the economy? Crowding-in might happen as a result of: Resource crowding in: More resources available for private sector investment Financial crowding in: Lower interest rates lead to rise in consumption and investment spending Net exports crowding in: Lower interest rates reduce the exchange rate which raises exports and reduces imports (c) Andrew Tibbitt 2017 16

17. Problem 2: Sovereign debt legacy Government borrowing leads to government debt. Servicing and sustaining this debt involves: Making interest payments on the debt (representing an opportunity cost to current and future generations) A potential loss of credit rating (leading to higher interest payments) Potential instability caused by need to re-borrow (sustain) the debt Future repayment of debt (imposing an opportunity cost on future generations in the form of high future taxes, loss of investment, lower productivity and future economic capacity) Possibility of debt cycle or debt trap (debt-interest-more borrowing-more debt) (c) Andrew Tibbitt 2017 17

18. Problem 3: Dealing with time lags (c) Andrew Tibbitt 2017 18 Inside lags Outside lag Recognition lag Action lag Implementation lag Effect lag Time to assess trends in the economy Time to decide to take action Time needed to enact new measures Time before measures change economy The operation of fiscal policy involves a number of time lags. T o be effective, f iscal measures have to be timed with care.

19. Problem 3: Dealing with time lags (c) Andrew Tibbitt 2017 19 Inside lags Outside lag Recognition lag Action lag Implementation lag Effect lag Time before measures change economy The operation of fiscal policy involves a number of time lags. T o be effective, f iscal measures have to be timed with care. RELATIVELY LONG FOR FISCAL POLICY RELATIVELY SHORT FOR FISCAL POLICY Time to assess trends in the economy Time to decide to take action Time needed to enact new measures

20. Problem 4: Expansionary bias of politicians (c) Andrew Tibbitt 2017 20 Fiscal policy is conducted by the government. Politicians are political! Politicians have to be re-elected and like to feel they are doing something – both of which encourage spending. There is a danger that temporary stimulus measures become permanent spending programs. To avoid this fiscal stimulus should be temporary .

21. Problem 5: Not letting the economy self-adjust Rather than stimulate the economy using expansionary fiscal policy measures, neo-classical economists recommend doing nothing and waiting for markets within the economy to self-adjust (e.g. a reduction of wages in labour markets). (c) Andrew Tibbitt 2017 21

22. Not letting the economy self-adjust Evaluation: It may take time for markets to adjust. A recession has its own opportunity costs (e.g. loss of output and capacity, social and economic problems of unemployment). (c) Andrew Tibbitt 2017 22

23. Advantages of using fiscal policy Direct effect on economy (especially government spending changes) – short outside or effect lag Flexible – different rates for different areas. Can affect different objectives. Good for two-speed economy. Automatic stabilisation (c) Andrew Tibbitt 2017 23

24. Disadvantages of using fiscal policy Long inside or action lag – only 1 budget a year. Complex to introduce changes . Need to consult with interest groups. Political interference. Possible negative multiplier effects as a result of crowding- out. Crowding-out (or crowding- in) may dampen impact. Debt legacy. State governments may undermine the federal government’s fiscal plans through their own spending plans. (c) Andrew Tibbitt 2017 24

25. Avoiding some of the problems Some of the problems of using fiscal policy to stimulate the economy can be avoided if the policy measures are: TIMELY (avoiding time lags) TARGETED (avoiding resource crowding out) TEMPORARY (avoiding politicians expansionary bias) (c) Andrew Tibbitt 2017 25

26. End of slide show (c) Andrew Tibbitt 2017 26