This paper analyzes likely effectiveness of the fiscal policy in supporting aggregate demand in Australia. The simulation analysis illustrates that the type of fiscal measure and the underlying behavioral responses have an important impact on the magnitude of fiscal multipliers. The Global Integrated Monetary and Fiscal Model simulations also suggest that the cumulative impact after five years could be close to 10 percentage points of GDP for the announced stimulus measures that cumulate to almost 8 percentage points of GDP.

Abstract

This paper analyzes likely effectiveness of the fiscal policy in supporting aggregate demand in Australia. The simulation analysis illustrates that the type of fiscal measure and the underlying behavioral responses have an important impact on the magnitude of fiscal multipliers. The Global Integrated Monetary and Fiscal Model simulations also suggest that the cumulative impact after five years could be close to 10 percentage points of GDP for the announced stimulus measures that cumulate to almost 8 percentage points of GDP.

I. The Effectiveness of Fiscal Stimulus Measures1

A. Introduction

1. With fiscal policy playing a central role in mitigating the impact of the global downturn, this chapter provides some insights on its likely effectiveness in supporting aggregate demand in Australia. The IMF’s Global Integrated Monetary and Fiscal Model (GIMF) is used to derive estimates of the potential aggregate demand impact of alternative fiscal measures and provides an estimate of the expected impact on GDP of the temporary discretionary measures announced by the Commonwealth government. The simulation analysis illustrates that the type of fiscal measure and the underlying behavioral responses have an important impact on the magnitude of fiscal multipliers. The GIMF simulations suggest that the cumulative impact after five years could be close to 10 percentage points of GDP for the announced stimulus measures that cumulate to almost 8 percentage points of GDP.

B. The Global Integrated Monetary and Fiscal Model

2. GIMF, a model of the world economy derived from optimizing foundations, embodies a detailed representation of fiscal policy. Fiscal authorities in GIMF consume goods, maintain public capital stocks, and provide transfers. These activities are financed through taxes on labor income, capital income, consumption expenditure, as well as non-distorting lump-sum taxes. For this application, a two-region version of the model has been calibrated to represent Australia and the rest of the world.2

3. GIMF’s non-Ricardian features allow fiscal policy to have a significant impact on household behavior. The overlapping generations structure of GIMF increases the potential impact that the fiscal authority can have on households’ consumption, saving, and labor supply decisions. Each period households face a constant probability of death. Because of this, households discount future tax liabilities as they may not be around to pay them. The implication is that fiscal choices regarding when and how to fund current spending or tax changes influence households’ responses and thus the macroeconomic impact of these policy actions. In addition, a portion of households face liquidity constraints that prevent them from accessing capital markets to smooth their consumption over time. These households simply spend their disposable income in each period, and this can amplify the impact of policy actions that alter disposable income.

4. Although public consumption expenditure in GIMF does not add directly to welfare, the public capital stock does. In the model, public capital adds to the productivity of private capital. This complementarity serves to increase the macroeconomic impact of public investment via productivity and private investment decisions.

C. Fiscal Multipliers

5. The GDP impact of alternative fiscal measures varies widely across instruments. The model-simulated impacts on output of temporary (one-year), one-percent-of-GDP increases in the fiscal deficit to fund a range of fiscal initiatives are presented in Table I.1. The results in the first column illustrate that direct government spending has the largest impact on aggregate demand with both government consumption and investment expenditures having multipliers larger than one. Transfers targeted to low-income (liquidity-constrained) households and reductions in value-added taxes have the next largest effects. Reductions in taxes on labor income and transfers to all households have small and similarly-sized multipliers while reductions in taxes on corporate profits have essentially a zero multiplier.

Table I.1.

Australia: Impact of Temporary Fiscal Measures on GDP

(Percent Deviation from Baseline)

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The sensitivity analysis included the degree of complementarity between private and public capital (base-case parameter 0.10, smallest 0.05, largest 0.20), households’ planning horizon (base case 20 years, shortest 10 years), and the proportion of liquidity constrained households (base case 30 percent, smallest 20 percent, largest 40 percent).

6. Sensitivity analysis illustrates how fiscal multipliers depend on key behavioral assumptions and the monetary authority’s response. Because GIMF is calibrated, it is useful to examine the sensitivity of the results to key calibration choices. For the fiscal measures considered, the degree of complementarity between private and public capital, the proportion of liquidity constrained households, and households’ effective planning horizons were found to be the calibration choices that have the largest impact on the magnitude of the fiscal multipliers. However, the results in Table I.1 (columns 2 and 3) illustrate that plausible ranges for these calibration choices do not alter the magnitudes of the multipliers by a significant amount.3 If monetary policy does not initially respond to the higher inflation resulting from the fiscal measures, the impact on GDP increases by a nontrivial amount (Table I.1, column 4).

D. The Impact of Announced Discretionary Fiscal Measures

7. As of the May 2009 Budget, the Commonwealth government had announced discretionary fiscal stimulus measures totaling almost 8 percent of GDP over five years. Table I.2 presents a breakdown of the measures that are heavily focused on public investment and transfers to low- and middle-income families, measures that the multiplier analysis suggests should be highly effective at stimulating activity.

Table I.2.

Australia: Fiscal Stimulus Measure as of May 2009 1/

(In Percent of GDP)

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These estimates are based on the material provided in the May 2009 Commonwealth Government Budget.

8. GIMF estimates suggest that the announced stimulus will likely have a cumulative impact after 5 years of close to 10 percentage points of GDP. Table I.3 presents the model-simulated impact of the stimulus measures on GDP under alternative behavioral assumptions. The estimated cumulative impacts on GDP after five years range between 5¼ and 12¾ percentage points. The lowest estimated cumulative impact of 5¼ percentage points assumes that only a small portion of households are liquidity constrained, the complementarity between private and public capital is very low, and monetary policy must be tightened in response to the fiscal easing. Given the current degree of stress in financial markets, the outlook for inflation, and obvious infrastructure bottlenecks in Australia, this estimate is likely too low. It is probably reasonable to expect the impact to be close to that achieved under the base-case calibration with monetary accommodation and highly targeted transfers, which would bring the cumulative impact over the five years close to 10 percentage points of GDP. The largest estimate of almost 13 percentage points of GDP, however, is not outside the realm of possibilities, particularly if the infrastructure projects are targeted toward areas where bottlenecks have constrained the commodity sector.

Table I.3.

Australia: GIMF Simulated Impact of Fiscal Stimulus on GDP 1/

(Percent Deviation from Baseline)

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This simulation is done assuming that in 2008, no one is aware of the fiscal stimulus introduced in 2009. However, from the start of 2009 and onwards, everyone is fully aware of the fiscal measures that will be taken over the subsequent 4 years.

It is assumed that 60 percent of the transfers go to households that face liquidity constraints and thus spend all the transfer. In this simulation, the monetary policy rate does not respond to the increase in inflation resulting from the stimulus until 2011.

9. The bill for the fiscal stimulus will eventually need to be paid with implications for real activity. In the simulations, the stimulus expenditures are financed with increased public borrowing until 2012. Beyond 2012, a fiscal consolidation occurs to return public debt relative to GDP back to its initial level. During the consolidation period, where taxes and/or spending adjust, the level of GDP will be lower than it otherwise would be if no fiscal consolidation was required.

1

Prepared by Ben Hunt (ext. 36361).

2

For a detailed description of GIMF, see Kumhof, M., and D., Laxton, 2007, “A Party without a Hangover? On the Effects of U.S. Government Fiscal Deficits,” IMF Working Paper, WP/07/202.

3

The only exception is the cumulative effect on GDP of the degree of complementarity between private and public capital. Doubling the degree of complementarity (0.10 to 0.20) increase the cumulative impact after 10 years on GDP from 2.25 percentage points to 3.85 percentage points. Cutting the degree of complementarily in half (0.10 to 0.05) reduces the cumulative impact on GDP to 1.48 percentage points.