Tutorial : Fiscal Policy

Period 1

Section A – Homework
1. What is fiscal policy? Who is responsible for fiscal policy?
Fiscal policy is defined as the use of taxation and government spending to influence
aggregate demand in order to achieve the government’s macroeconomic objectives.
Generally, it is the government that is responsible for designing and implementing
fiscal policies. It is the President, Vice President, Minister of Finance and other economic
advisors who makes the decisions and weigh their options to determine which instruments
and what kind of fiscal policy (expansionary or contractionary fiscal policy) to implement
that will benefit their people and also achieve their macroeconomic objectives, eliminating
trade offs when it is possible.

2. What is the difference between fiscal policy and monetary policy?

Monetary policy is defined as the use of interest rates, direct control of the money
supply and the exchange rate to influence the aggregate demand. Monetary policy involves
measures and monetary policies to influence the price or quantity of money.

Although both fiscal policy and monetary policy seek to influence aggregate demand,
they differ in terms of their instruments and their effectiveness (impact). Fiscal policy
involves the use of taxation (ex: corporate tax, income tax, etc) and government spending.
Whereas, monetary policy involves the use of interest rate, money supply and exchange rate.
For example, both fiscal policy and monetary policy can be used to combat budget
deficit (government spending > government revenue). In terms of fiscal policy,

3. What is the difference between government purchases and government expenditures? Are
government expenditures higher today than they being in 1970?

4. What is expansionary fiscal policy? What is contractionary fiscal policy?

Expansionary fiscal policy is designed to increase aggregate demand. This can be
achieved by the government increasing its government spending / expenditures and or cutting
taxes implemented (or the tax base, reducing the amount of people paying taxes). Thus,
expansionary fiscal policy is used to reduce recession, stimulate the economy and increase
economic growth (fix deflation and cause inflation). This increase in government spending
contributes to transfer of payments and financial aids given to the vulnerable members of the
society or firms that are struggling to stay in the market and stay competitive. Transfer of
payments increases their disposable income and increases demand and consumption. Cutting
tax also increases household disposable income and provides extra capital for firms to spend
or allocate on production costs and even invest in research and development.

In contrast, contractionary fiscal policy is the opposite of expansionary fiscal policy.

Contractionary fiscal policy is designed to decrease aggregate demand. This can be achieved
by the government reducing its government spending / expenditures and or increasing the
taxes implemented (gain more tax revenue). Expansionary fiscal policy can be used to
improve a country’s balance of payments (during a budget deficit) as it reduces the total
expenditure and boosts tax revenue. An increase in income tax reduces disposable income of
households and in turn reduces imports and improves its current account balance (reduce a
current account deficit and increase a current account surplus). A reduction in government
spending directly reduces the demand for goods and services, reduces imports and puts
pressure on domestic firms to increase their exports.

Section B
5. Briefly explain whether each of the following is: (i) an example of discretionary fiscal
policy, (ii) an example of an automatic stabilizer, or (iii) not an example of fiscal policy.
a. The government increase spending on rebuilding towns devastated by fires.
b. The Central sells government bonds.
c. The total amount the government spends on unemployment benefits decreases during an
economic expansion.
d. The revenue the government collects from the individual income tax declines during
contraction.
e. The government increases the excise tax on petrol to encourage the use of alternative fuels
or means of transport
f. During a downturn in economic growth, the government approves new spending on new
railway lines and stations.
6. Identify each of the following as (i) part of an expansionary fiscal policy, (ii) part of a
contractionary fiscal policy or (iii) not part of fiscal policy.
a. The company income tax rate is increased.
b. Defence spending is increased.
c. Families are allowed to deduct all their expenses for child care from their taxable income.
d. The personal income tax rate is decreased.
e. The government builds a new highway in an attempt to expand employment in the state.

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7. Use the following graph to answer these questions.
 a. If the government
does not take any policy actions, what will be the values of real GDP and the price level in
2017?
b. What actions can the government take to bring real GDP to its potential level in 2017?
c. If the government takes no policy actions, what will be the inflation rate in 2017? If the
government uses fiscal policy to keep real GDP at its potential level, what will be the
inflation rate in 2017?

8. The hypothetical information in the following table shows what the situation will be in
2016 if the government does not use fiscal policy:

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a. If the government wants to move real GDP to its potential level in 2016, should it use
expansionary policy or contractionary policy? In your answer make sure you explain whether
the government should be increasing or decreasing government purchases and taxes.
b. If the government is successful in moving real GDP to its potential level in 2016, state
whether each of the following will be higher, lower or the same as it would have been if they
had taken no action:
i. Real GDP
ii. Potential GDP
iii.The inflation rate
iv.The unemployment rate.
c. Draw a dynamic aggregate demand and aggregate supply graph to illustrate your answer.
Make sure that your graph contains LRAS curves for 2015 and 2016; SRAS curves for 2015
and 2016; AD curves for 2015 and 2016, with and without fiscal policy action; and
equilibrium real GDP and the price level in 2016, with and without fiscal policy.

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Period 2

Section A – Homework
1. Define the government purchases multiplier and the tax multiplier.
2. What is meant by crowding out? What is the difference between financial crowding out and
resource crowding out?

3. Suppose that real GDP for an economy is currently $13.1 trillion, potential GDP is $13.5
trillion, the government purchases multiplier is 2 and the tax multiplier is –1.6.
a. Holding other factors constant, by how much will government purchases need to be
increased to bring the economy to equilibrium at potential GDP?
b. Holding other factors constant, by how much will taxes have to be cut to bring the economy
to equilibrium at potential GDP?
c. Construct an example of a combination of increased government spending and tax cuts that
will bring the economy to equilibrium at potential GDP.

Section B

4. If the short-run aggregate supply (SRAS) curve were a horizontal line at the current price
level, what would be the effect on the size of the government purchases and tax multipliers?

5. In what ways does the federal budget serve as an automatic stabiliser for the economy?

6. Explain the effect that each of the following fiscal policy measures could have on aggregate
supply.
a. The reduction of taxes on capital gains
b. Reducing the higher marginal income tax rates to the same level as the company income tax
rate
c. Increasing the marginal income tax rates paid by individuals

7. Use the dynamic aggregate demand and aggregate supply model to explain what fiscal
policy stance the Government of Australia should take if the economy is entering a period of
recession.

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When answering questions based on articles, please note the following
steps; Step 1: Read all the questions from the article.
 Step 2: Number all the paragraphs in the article

Step 3: Browse through the article and match the questions and the
paragraphs Step 4: Write the answers to the questions

(Do not try to understand each and every word in the article)

8. Read the article and answer the following questions

i. According to the article, what is the fiscal stance of the Japanese government?

ii. According to the article, what are the expected outcomes of the above mentioned fiscal
stance?
iii.When the economy is at its potential GDP level, do you think there is a role for fiscal
policy? Why or why not?

2 AUGUST 2016
Japan cabinet approves $175b fiscal boost
Japanese Prime Minister Shinzo Abe’s cabinet has approved Y13.5 trillion ($A174.96 billion)
in fiscal measures as part of efforts to revive the flagging economy, with cash payouts to low
income earners and infrastructure spending.
The stimulus spending is part of a renewed government effort to coordinate its policy with the
Bank of Japan, but growing concerns that the BOJ policy has reached its limit triggered the
worst sell-off in government bonds in three years.
‘We compiled today a strong economic package draft aimed at carrying out investment for the
future,’ Abe told a meeting of cabinet ministers and ruling party executives on Tuesday
morning. ‘With this package, we’ll proceed to not just stimulate demand but also achieve
sustainable economic growth led by private demand.’
The headline figure for the package totals 28.1 trillion yen, but it includes public–private
partnerships and other amounts that are not direct government outlays and thus may not give
an immediate boost to growth.
Abe ordered his government last month to craft a stimulus plan to revive an economy dogged
by weak consumption, despite three years of his ‘Abenomics’ mix of extremely
accommodative monetary policy, flexible spending and structural reform promises. The
package comes days after the Bank of Japan eased policy again and announced a plan to
review its monetary stimulus program in September, which has kept alive expectations for
‘helicopter money’, printing money for government debt.
The expected appointment of Toshihiro Nikai, an advocate of big public works spending, to
the No. 2 post of Abe’s ruling party in tandem with a cabinet reshuffle on Wednesday

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underscores Abe’s shift toward his ‘second arrow’ of fiscal policy amid concerns monetary
easing is reaching its limits.
Precisely how the spending will be financed is unclear, although the government is
considering issuing construction bonds when compiling a supplementary budget later this
year. The stress on fiscal steps is raising doubts about Japan’s ability to fix its already
massive debt.
The government estimates the stimulus would push up real gross domestic product (GDP) by
around 1.3 per cent in the near term. The package will be implemented over several years,
officials added.
Source: News.com.au (2016), ‘Japan cabinet approves $175b fiscal boost’, New.com.au, 2
August, AAP, at <www.news.com.au>, viewed 8 November 2016.

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