fiscal policy

Question 1

Fiscal policies

Answer 1

• Fiscal Policy involves the government changing the levels of taxation and gov’t spending in order to influence aggregate demand (AD)
• Expansionary (or loose) Fiscal Policy. This involves increasing AD. Therefore the govt will increase spending (G) and / or cut taxes (T). It will lead to a bigger budget deficit.
• Deflationary (or tight) Fiscal Policy. This involves decreasing AD. Therefore the govt will cut govt spending (G) and increase taxes (T). It will reduce the budget deficit.

Question 2

stabilisers

Answer 2

Automatic stabilisers - If the economy is growing, people will automatically pay more taxes (VAT and Income tax) and the government will spend less on unemployment benefits. The increased T and lower G will act as a check on AD. In a recession, borrowing will increase because tax revenues fall and spending on benefits increases.
Discretionary stabilisers - This is a deliberate attempt by the government to affect AD and stabilise the economy, e.g. in a boom the government could increase taxes to reduce inflation.

Question 3

Injections and withdrawals

Answer 3

Injections (J): These are an increase of expenditure into the circular flow, it includes: Govt spending (G), Exports (X) and Investment (I)
Withdrawals (W): These are leakages from the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M)

Question 4

The Multiplier Effect

Answer 4

This occurs when an initial injection into the economy causes a bigger final increase in national income.
Multiplier (k) = Change in real GDP (Y)/Change in Injections (J)

Question 5

The value of the Multiplier depends upon

Answer 5

• MPC - If people spend a high % of any extra income, then there will be a big multiplier effect.
• However if any extra money is withdrawn from the circular flow the multiplier effect will be very small.

Question 6

Marginal propensity

Answer 6

1. Marginal Propensity to Consume (mpc). This is the % of any extra income that a person spends.
2. Marginal Propensity to Withdraw (mpw). This is when money is withdrawn from the circular flow it includes mpt (tax) + mpm (import) + mps (save)
   multiplier (k) = 1/1-mpc = 1/mpw

Question 7

Evaluation of Fiscal Policy 1

Answer 7

1. Disincentives to work - Increasing taxes to reduce AD may cause disincentives to work; if this occurs there will be a fall in productivity and LRAS could increase at a slower rate
2. Reduced public services - Reduced govt spending to reduce AD could affect public services. In theory, expansionary fiscal policy could help fund investment in infrastructure, but it depends whether government spending is efficiently targeted on projects that help improve AS.
3. Poor information - To predict future inflation and growth is not easy, therefore it may be difficult to know how much to increase or decrease AD.

Question 8

Evaluation of Fiscal Policy 2

Answer 8

4. Time Lags - If the govt plans to increase spending this can take a long time to filter into the economy and it may be too late to have the desired effect in recovering from recession.
5. Increase in budget deficit - Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget deficit, which can have adverse effects, such as higher bond yields.
6. Depends upon other components of AD - If consumer confidence is very low, reducing income taxes may not lead to an increase in consumer spending and fiscal policy will be ineffective in boosting demand. If there is a global economic downturn, expansionary fiscal policy may also be ineffective because exports (X) will be falling – offsetting rise in government spending (G).

Question 9

Evaluation of Fiscal Policy 3

Answer 9

7. Monetarist Critique - Monetarists argue that the LRAS is inelastic; therefore an increase in AD will only cause inflation to increase in the long run.
   • Monetarists argue that extra govt spending will cause crowding out. This means the extra govt spending leads to a fall in private sector spending because the private sector are lending their funds to the government.
   • The Keynesian view rejects this. They argue the economy can be below full capacity for a long time, therefore there will not be any crowding out because the govt will be using unused resources. Therefore in a recession, expansionary fiscal policy can play an important role in increasing real GDP.
8. Depends on size of the multiplier - If the multiplier is significant, e.g. greater than one. This means expansionary fiscal policy will be more effective in boosting aggregate demand.

Question 10

Supply side effects of fiscal policy

Answer 10

Lower income tax may increase incentive to work
Higher government spending on education and training, could increase long-term labour productivity. But, also government spending could be inefficient and wasteful – it depends what government spends on.

Question 11

Multiplier more

Answer 11

Increase in injections (investment) - increase in wages - increase in AD (injection ) and so on