Economics for Decision Making 1: Written Assignment on Fiscal Policy

This economics assignment delves into the complexities of fiscal policy, examining the impact of government budget deficits and their implications for economic stability. The assignment begins by defining government budget deficits and their effects on income redistribution across generations, emphasizing the importance of spending on future welfare, such as education and healthcare. It references data from the IMF and government sources in the US and Australia to illustrate the prevalence and composition of government spending. The assignment then analyzes the effects of fiscal policy, particularly contractionary fiscal policy, using the aggregate demand and aggregate supply model to explain how government actions can influence output and price levels. Furthermore, it explores the concept of the fiscal multiplier, demonstrating how changes in government expenditure can have amplified effects on aggregate demand and overall economic activity. The solution provides a comprehensive analysis of fiscal policy tools and their effects on macroeconomic indicators, supported by relevant figures and data sources.

Running head: ECONOMICS
Economics
Name of the Student
Name of the University
Course ID

1ECONOMICS
Table of Contents
Question 1........................................................................................................................................2
Question 2........................................................................................................................................5
Question a....................................................................................................................................5
Question b....................................................................................................................................6
References........................................................................................................................................7

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Question 1
Government budget deficit reflects a situation where expenditure incurred by government
is above the revenue. Higher amount of deficit enables a redistribution of income across
generation. When spending exceeds today’s revenue then this shows a welfare for today. The
next generation however have to pay for it. To benefit the economy the extra spending needs to
be spent on welfare of next generation such as building schools and hospitals. Most of the
developed countries usually run with a government deficit but still maintains a good economic
health.
Table 1: General government budget balance for advanced economies
(Source: imf.org, 2019)
The table above shows deficit in government budget as percentage of GDP. Most of the
advanced countries of the world experienced deficit in the government budget. The composition
of government spending determines their economic success. For example, in United State the
single biggest component of government spending is education which not only includes support
to school education but also extended support to college and university education.

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Figure 1: Share of education spending in local and state government expenditure in United
State
(Source: bea.gov, 2019)
Figure 2: Composition of Federal government spending in United State
(Source: whitehouse.gov, 2019)

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Figure 3: Composition of government expenditure in Australia
(Source: taxsuperandyou.gov.au, 2019)
Like United State, the commonwealth government in Australia spends a significant
portion of total spending on health and education rather than spending on consumer goods and
therefore benefiting the next generation.
Despite the positive sides of government deficit given the nature of spending composition
there are some adverse effect of increasing government deficit. Deficit by increasing interest rate
crowds out private investment. This by lowering private investment lower economic growth.
Another concern related to government deficit is the occurrence of monetized inflation because
of printing of excessive money to buy government securities.

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Question 2
Question a
Figure 4: Inflationary gap and contractionary fiscal policy
The above figure depicts the scenario where actual real GDP exceeds the potential GDP.
Macroeconomic equilibrium is attained where aggregate demand matches with aggregate supply.
Suppose initially equilibrium is at E where aggregate demand intersects the aggregate supply.
Equilibrium level of real GDP is YE and corresponding price level is at P*. The potential GDP
however is at YP, below the actual real GDP. Since, actual real GDP is above the potential GDP
there exists an inflationary gap. In order to get to potential GDP government should adopt a
policy of fiscal policy contraction which helps to lower output and price level in terms of
lowering aggregate demand. Fiscal policy contraction can be done either by lowering spending
or by increasing tax rate. Decrease in government spending directly lowers aggregate demand
since this is a direct component of aggregate demand. When government increases tax rate then

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this reduces aggregate demand through lowering disposable income. In both the cases aggregate
demand lowers shifting the aggregate demand curve to the left to AD1. With this the equilibrium
shifts from E to E1. This kind of policy reduces inflationary pressure moving the actual GDP
towards the potential GDP along with a decline in price level.
Question b
Figure 5: Impact of fiscal multiplier
Because of the fiscal multiplier aggregate demand changes by a greater amount than
initial change in government expenditure. When government lowers its expenditure, aggregate
demand curve first shifts left by the amount of decline in government expenditure. It is the
existence of fiscal multiplier which intensifies the impact. The value of spending multiplier is
1/MPS. As MPS lies between 0 and 1, the absolute value of the multiplier is greater than 1. This
intensifies the induced effect of government spending helping the government in terms of the
spending commitments to attain full employment output.

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References
bea.gov (2019) U.S. Bureau of Economic Analysis (BEA).Bea.gov. Retrieved 14 January 2020,
from https://www.bea.gov/
imf.org (2019). Fiscal Monitor, April 2015 : Now Is the Time: Fiscal Policies for Sustainable
Growth. IMF. Retrieved 14 January 2020, from
https://www.imf.org/en/Publications/FM/Issues/2016/12/31/Now-Is-the-Time-Fiscal-
Policies-for-Sustainable-Growth
taxsuperandyou.gov.au (2019).The Budget: taxes and spending | Tax Super and You.
Taxsuperandyou.gov.au. Retrieved 14 January 2020, from
https://www.taxsuperandyou.gov.au/node/131/take
whitehouse.gov (2019) Historical Tables | The White House. The White House. Retrieved 14
January 2020, from https://www.whitehouse.gov/omb/historical-tables/