Chapter 8: Fiscal Policy (Video)

Vocabulary flashcards covering key fiscal policy concepts from the lecture notes.

Fiscal policy

Measures undertaken by governments relating to taxation and government expenditure to influence aggregate demand and achieve economic objectives.

Automatic stabilisers

Mechanisms that automatically dampen the business cycle without new policy action, such as progressive taxes and unemployment benefits.

Discretionary fiscal policy

Deliberate government actions to influence aggregate demand, typically through changes in government spending (G) and taxes (T).

Cyclical/non-discretionary fiscal policy

Automatic stabilisers that respond to the business cycle; no new legislation is required.

Budget surplus

When government revenue exceeds government expenditure in a financial year.

Budget deficit

When government expenditure exceeds government revenue in a financial year.

Budget balance

The overall difference between revenue and expenses; can be a surplus, deficit, or balanced.

Fiscal balance

The budget outcome measured as revenue minus expenses, including depreciation and superannuation liabilities.

Underlying cash balance

Budget outcome based on cash receipts minus cash payments, excluding asset sales and one-off payments.

Expansionary fiscal policy

Policies that increase aggregate demand, typically by increasing government spending or cutting taxes.

Contractionary fiscal policy

Policies that reduce aggregate demand, typically by reducing government spending or increasing taxes.

Progressive income tax

A tax system where the marginal tax rate rises as income increases, acting as an automatic stabiliser.

Unemployment benefits

Transfers to the unemployed that rise with unemployment, acting as an automatic stabiliser.

Crowding out

When government borrowing raises interest rates and reduces private investment spending.

Deficit financing

Methods to fund a budget deficit, such as issuing government bonds or monetary financing.

Bond financing

Financing deficits by selling government bonds to the public; does not increase the money supply.

Monetary financing

Financing deficits by lending from the central bank; typically inflationary and rarely used.

Incidence of taxation

Who ultimately bears the burden of a tax; can be direct or indirect.

Direct taxation

Tax borne by the person or entity taxed (e.g., income tax, company tax).

Indirect taxation

Tax collected from producers or sellers that is passed on to consumers (e.g., GST, excise, customs).

Adam Smith’s principles of taxation

Equity, economy in collection, certainty, and convenience; foundations for tax design.

Equity (Adam Smith)

The rich should pay more tax than the poor.

Economy in collection

Low cost of collecting the tax.

Certainty

Taxpayers should be certain of when tax applies, how much is paid, and how the rate is calculated.

Convenience

Tax payment should be convenient and not impose undue burden.

Taxation criteria

Modern adaptation: equity, efficiency, and simplicity.

Proportional tax

A tax that takes the same percentage of income from everyone regardless of income level.

Progressive tax

Tax rate increases as income increases.

Regressive tax

Tax rate decreases as income increases; higher burden on lower-income earners.

Goods and Services Tax (GST)

Indirect tax levied at a uniform rate (often 10%) on most goods and services; revenue typically allocated to states.

Company tax

Tax on company profits; in Australia commonly around 25%; franking credits apply to shareholders.

Income tax (Personal income tax)

Direct tax on individuals’ earnings, with brackets shaping the rate.

Petroleum Resource Rent Tax

Tax on offshore/onshore oil and gas projects.

Customs duty

Tax on imported goods to protect local industries and for revenue.

Excise duty

High rates on selected goods (e.g., alcohol, tobacco, fuel); often inelastic demand.

Fringe Benefits Tax

Tax on non-cash benefits provided by employers to employees.

Multiplier

The ratio of change in GDP to an initial change in autonomous spending; commonly 1/(1-MPC).

MPC (Marginal Propensity to Consume)

The portion of an additional dollar of income that is spent on consumption.

MPS (Marginal Propensity to Save)

The portion of an additional dollar of income that is saved.

MPT (Marginal Propensity to Tax)

The portion of an additional income that is taxed.

MPM (Marginal Propensity to Import)

The portion of an additional income spent on imports.

Keynesian multiplier with taxes and imports

A more complete multiplier: 1 / (MPS + MPT + MPM).

Inflationary gap

A situation where actual GDP exceeds potential GDP, creating inflationary pressure.

Deflationary gap

A situation where actual GDP is below potential GDP, indicating underutilized resources.

Phillips curve

Trade-off between inflation and unemployment; short-run inverse relationship.

Inside lag

Time to recognize, decide, and implement policy actions.

Outside lag

Time for policy effects to influence real GDP and employment.

Time lags

Combined effects of inside and outside lags that can affect policy effectiveness.

Define monetary policy

Monetary policy is the Reserve Bank of Australia’s (RBA) use of tools, primarily the cash rate, to influence the cost and availability of credit in the economy to achieve macroeconomic objectives such as low inflation, sustainable growth, and full employment.

What is the main tool the RBA uses to conduct monetary policy?

The cash rate target (official interest rate).This rate influences borrowing costs and economic activity.

What is the RBA’s inflation target?

2–3% per year

Explain the difference between headline inflation and underlying inflation.

Headline inflation measures the total change in the CPI, including volatile items (e.g., fuel, food). Underlying inflation removes these volatile items to reveal the long-term trend.

Who sets the cash rate and how often do they meet?

The RBA Board sets the cash rate and meets 11 times a year (usually the first Tuesday of each month except January).

List the three main objectives of monetary policy.

(1) Stability of the currency (low inflation), (2) Full employment, (3) Economic prosperity and welfare of the people.

What is the difference between expansionary and contractionary monetary policy?

Expansionary lowers interest rates to encourage borrowing/spending; contractionary raises interest rates to slow borrowing/spending and reduce inflation.

What are open market operations and how do they influence the cash rate?

The buying/selling of government securities by the RBA to influence the supply of funds in the cash market, which moves the cash rate towards the target.

Explain why the RBA is independent but also accountable.

Independent because it makes decisions without government interference; accountable because it reports to Parliament and explains its decisions publicly.

Identify two factors that influence the RBA’s decision-making.

Inflation rate, unemployment rate, GDP growth, global economic conditions, exchange rate, commodity prices.

If inflation is at 5% and unemployment is 3.5%, would the RBA likely adopt an expansionary or contractionary stance, and what would they do with the cash rate?

Contractionary stance; they would raise the cash rate to reduce inflation.

Explain how a strong Australian dollar might influence the RBA’s monetary policy decision.

A strong AUD makes imports cheaper (reducing inflation) but can hurt exports; the RBA might lower interest rates to stimulate domestic growth.

Outline the transmission mechanism of how lowering the cash rate can stimulate economic growth.

→ Lower cash rate → banks lower lending rates → cheaper borrowing for households/businesses → increased consumption and investment → higher aggregate demand → economic growth.

State one strength and one limitation of monetary policy.

→ Strength: Can be adjusted monthly and implemented quickly.
→ Limitation: Less effective during low consumer/business confidence or when interest rates are already very low.

Give one example of when monetary policy might be less effective in achieving its goals.

In a recession when confidence is low and people are unwilling to borrow even if rates are cut.