achievement of domestic macroeconomic goals and living standards

Of course, budget deficits certainly have their place over the shorter term, especially when the economy is weak and in need of stimulus. However, if not carefully managed, government debt can get out of hand. The economic woes experienced by some European countries (Greece, Italy, Spain, Cyprus) are all examples of what might happen if there are far too many budget deficits. In particular, the country may lose its strong AAA credit rating (which allows it to borrow at lower interest rates), because of the increased risk of default on repayments. The government would also be in a weakened financial position to deal with an economic crisis, if it already had high levels of debt and no fighting fund accumulated from previous budget surpluses. In addition, debt run up now adds to the burden on future generations who are left to pay it back through higher taxes and/or lower budget outlays on important services. Either way, continued budget deficits would lower their living standards. Resourceseses Resources Weblinks Ways that governments reduce federal debt Deficits & debts 4.5 Activities

Students, these questions are even better in jacPLUS

Receive immediate feedback and access sample responses Access additional questions

Track your results and progress Find all this and MORE in jacPLUS 4.5 Quick quiz 4.5 Exercise 4.5 Exercise 1. Define the term budget outcome. 2 marks 2. Describe the three types of budget outcome. 3 marks 3. Explain how a budget deficit might be financed. 2 marks 4. Explain how money from a budget surplus might be used. 2 marks 5. a. Distinguish the following pairs of terms: i. A budget deficit and a budget surplus 2 marks ii. A headline budget deficit and an underlying budget deficit. 2 marks b. Assume the government runs a budget deficit of $215 billion. Identify and outline the various options available to the government for financing this deficit. 3 marks c. Identify two important economic problems associated with running budget deficits in the long-term. 2 marksUNCORRECTED PAGE PROOFS d. Identify two important advantages of reducing the deficit and returning to budget surplus as soon as possible. 2 marks e. Explain the medium-term operational goal of budgetary policy. 2 marks

6. The Australian government would like to reduce the size of its budget deficit. Outline two key options available that could be used to reduce the size of the budget deficit, assuming this was the main priority.

4 marks

7. Other things being equal, outline how any four of the following events would be likely to affect budget receipts, budget outlays and the actual outcome of the Australian government’s budget. 4 marks i. A rise in domestic consumer and business confidence ii. The slower rate of economic growth in China iii. A rise in the unemployment rate from 5.0 per cent to 6.4 per cent iv. An acceleration of wages growth v. An ageing population with a declining proportion of people of working age vi. A serious flu or COVID-19 epidemic spreading.

Fully worked solutions and sample responses are available in your digital formats. 4.6 The stance of budgetary policy — is it expansionary or contractionary?

KEY KNOWLEDGE • the stance of budgetary policy: expansionary or contractionary.

Source: VCE Economics Study Design (2023–2027) extracts © VCAA; reproduced by permission The term, budget stance, relates to whether the change in the budget outcome (i.e. a deficit, balance or surplus) is intended to have an expansionary (accelerating), neutral, or contractionary (slowing) impact on the level of AD (AD = C+I+G+X−M) and economic activity. Figure 4.8 shows that there are three main types of budget stance — an expansionary stance, neutral stance and contractionary stance.

FIGURE 4.8 The three types of budget stance and their impacts on the level of AD and economic activity The three main types of budget stance (as influenced by the budget outcome and size of the surplus or deficit) 1. An expansionary stance using a budget deficit BUT ... 2. A neutral stance using a budget balance ... • Has neither an expansionary nor contractionary impact on the level of AD and economic activity

3. A contractionary stance using a budget surplus BUT ... • A bigger surplus against the previous year has a more contractionary impact on the level of AD and economic activity • A smaller surplus against the previous year has a less contractionary impact on the level of AD and economic activity • A bigger deficit agaisnt the previous year has a relatively more expansionary impact on the level of AD and economic activity • A smaller deficit against the previous year has a less expansionary impact on the level of AD and economic activity UNCORRECTED PAGE PROOFS One guide to the type of budget stance being adopted is the budget outcome (i.e. the difference in total value between budget receipts and budget outlays). On the one hand, receipts tend to slow AD, while on the other, outlays tend to lift AD.

4.6.1 Using the size of the deficit or surplus to help decide the budget’s stance

You may recall from earlier reading, that there are two ways of representing data related to the budget outcome: • The outcome can simply be expressed in absolute terms as a certain number of dollars. • Alternatively, the outcome can be compared with the size of the economy and expressed as a percentage of

GDP.

While both can be used the latter is preferred because, given that the size of the economy changes over time, it tells us more clearly whether the deficit or surplus is relatively bigger or smaller in terms of its impact on AD and economic activity. A relatively expansionary budget stance Normally, budget deficits are seen as expansionary because less is taken out in tax and other receipts, than is returned through government spending and other outlays. Thinking of the five-sector circular flow model, budget deficits tend to boost AD and economic activity. As we shall soon see, this means they can be used as a government policy to lift the economy in a slowdown or recession, thereby helping to promote the achievement of Australia’s macro gaols and better living standards. However, in evaluating the impact of expansionary budgets, it is especially important to look at the change in the size of the deficit, over a period of time, to determine whether the stance is becoming more expansionary or less expansionary: • Hypothetically, for example, the budget stance would become more expansionary if the size of the budget deficit increased from say 5 per cent of GDP (or perhaps $10 billion in absolute dollar terms), to 10 per cent of GDP (possibly $20 billion). • In reverse, the budget stance would be described as less expansionary if the deficit was cut from 10 per cent of GDP to 5 per cent of GDP. A relatively contractionary budget stance Normally, budget surpluses are seen as contractionary because more is taken out in tax and other receipts, than is returned through government spending and other outlays. Again thinking of the circular flow model, budget surpluses tend to slow AD and economic activity, making them a potentially useful policy in controlling booms or periods of inflation. Even so, it’s the change in the size of the surplus that decides the budget’s relative impact and whether the stance is becoming more contractionary or less contractionary: • So, the budget stance would be described as more contractionary if the size of the budget surplus increased from 5 per cent of GDP (or in dollar terms, perhaps $10 billion) to 10 per cent of GDP (possibly $20 billion). • In reverse, we would say that the budget stance had become less contractionary if the surplus was reduced from 10 per cent of GDP to 5 per cent of GDP. Resourceseses Resources Weblinks Expansionary fiscal policy How government uses fiscal policy to influence the economy UNCORRECTED PAGE PROOFS 312 Key Concepts VCE Economics 2 Units 3 & 4 Eleventh Edition

Students, these questions are even better in jacPLUS

Receive immediate feedback and access sample responses Access additional questions Track your results and progress

Find all this and MORE in jacPLUS

4.6 Quick quiz 4.6 Exercise

4.6 Exercise 1. Define a contractionary budget stance and explain when this be used. 2 marks 2. Define an expansionary budget stance and explain when this be used. 2 marks 3. Explain how you would determine whether the budget stance is expansionary or contractionary. 2 marks 4. a. Distinguish between an expansionary budget stance and contractionary stance. 2 marks b. Examine table 4.4 showing changes in the Australian government’s underlying budget outcome. TABLE 4.4 The Australian government’s actual and estimated underlying budget outcome

Year 2017–18 2018–19 2019–20 2020–21 2021–22* 2022–23*

Federal government underlying budget outcome ($ billions) −10.1 −0.7 −85.3 134.2 −99.2 −98.9 Federal government underlying budget outcome (percentage of GDP) −0.5 0 −4.3 − 6.5 −4.5 −4.4

*Note: Budget estimates as at MYEFO December Source: © Commonwealth of Australia 2021. Giving reasons and quoting data from the table, describe the change in the budgetary policy stance adopted between each of the following periods: i. the change in 2019–20 against 2018–19 1 mark ii. the actual and forecast changes during 2021–22 and 2022–23, against the actual outcome for 2020–21. 1 mark Fully worked solutions and sample responses are available in your digital formats. 4.7 The roles of automatic and discretionary stabilisers in affecting the budget’s outcome and stance, and the impact on the level of government debt KEY KNOWLEDGE • the role of automatic stabilisers (cyclical component of the budget) in influencing aggregate demand and stabilising the business cycle UNCORRECTED PAGE PROOFS • the role of discretionary stabilisers (structural component of the budget) in influencing aggregate demand and stabilising the business cycle • the effect of automatic and discretionary changes in the budget on the budget outcome and government (public) debt.

Budgetary policy is a very important macroeconomic or aggregate demand policy. During an economic slowdown when GDP growth is below trend, unemployment is high and inflation is low, governments often use Keynesian economic theory and apply expansionary aggregate demand budgetary policies designed to boost spending and the level of economic activity.

One of the functions of the Australian government is to regulate or stabilise the level of AD and hence economic activity, thereby helping to create conditions optimal for FIGURE 4.9 As seen in Australia, this economic stimulus typically involves budget deficits. However, a downside of deficits is the achievement of key domestic macroeconomic goals that the level of government debt can rise, and living standards. As an aggregate demand strategy, increasing the burden on future generations. budgetary policy is one way of regulating spending, so as to help reduce the severity of booms and recessions that are typical of the normal business cycle. To moderate instability and the business cycle, a countercyclical budgetary policy application is required and is illustrated in figure 4.10. • In a cyclical slowdown (where there is weaker growth and higher unemployment), the budget stance typically becomes progressively more expansionary to boost AD and the level of economic activity. • During a cyclical upswing in economic activity, the budget outcome typically becomes more contractionary to slow the growth in AD to a sustainable rate.

FIGURE 4.10 Changing the stance of budgetary policy in a countercyclical way to help soften or flatten out the severity of the business cycle An economy’s business cycle diagram 6 4 0 –2 In a boom, a more contractionary budget stance is used, typically involving large budget surpluses, to slow AD In a trough, the budget stance gradually switches to become expansionary, typically involving small budget deficits to stimulate AD

Rate of growth in GDP/economic activity (annual percentage change) During a slowdown, the budget stance gradually becomes less contractionary, with smaller surpluses

Desired trend rate of economic growth at 3% (domestic stability) Time in years

In a recession, the budget becomes highly expansionary, typically involving larger budget deficits to lift AD

During a recovery, the budget stance gradually switches to become more contractionary, typically involving an increase in the budget surplus

2

Permission clearance pending UNCORRECTED PAGE PROOFS

For the budget outcome to become either more expansionary (with bigger deficits) or more contractionary (with bigger surpluses) in this way, it must rely on two types of stabilisers: • automatic stabilisers (also called cyclical stabilisers) • discretionary stabilisers (also called structural stabilisers).