Fiscal Policy

Question 1

Define the Fiscal Policy.

Answer 1

• Involves the government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity.

Question 2

What is Aggregate Demand?

Answer 2

is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)

Question 3

What is the Aggregate Demand equation?

Answer 3

AD = C (Consumer Spending) + I (Capital Investment) + G (Government Spending) + X(Exports) – M(Imports)

Question 4

What is the Purpose of the Fiscal Policy?

Answer 4

• Stimulate economic growth in a period of a recession. - Keep inflation low (UK government has a target of 2%) - Fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic cycle.

Question 5

What other policy is the Fiscal Policy often used with?

Answer 5

Monetary Policy

Question 6

Which policy do the government prefer to use?

Answer 6

Monetary Policy

Question 7

Describe the process of Expansionary Fiscal Policy?

Answer 7

• This involves increasing AD. - Therefore the government will increase spending (G) and cut taxes (T). Lower taxes will increase consumers spending because they have more disposable income (C) - This will tend to worsen the government budget deficit, and the government will need to increase borrowing.

Question 8

Diagram showing Expansionary Fiscal Policy effect.

Answer 8

Question 9

Descibe the Process of Deflationary Fiscal Policy.

Answer 9

• This involves decreasing AD.
• Therefore the government will cut government spending (G) and/or increase taxes. Higher taxes will reduce consumer spending (C)
• Tight fiscal policy will tend to cause an improvement in the government budget deficit.

Question 10

Diagram showing the effect of Defaltionary Fiscal Policy.

Answer 10

Question 11

What type of Fiscal Policy did the government persure in 2009?

Answer 11

Expansionary Fiscal Policy

Question 12

Why did the government try to persue Expansionary Fiscal Policy in 2009?

Answer 12

• In response to a deep recession (GDP fell by 6%)
• Cut VAT in a bid to increase consumer spending

Question 13

When government power shifted what did the government decide to do in 2010?

Answer 13

• They argued deficit was too high and so cut government spending
• This involves spending limits
• And austerity measures

Question 14

What does Fiscal Stance mean?

Answer 14

• This refers to whether the government is increasing AD or decreasing AD, e.g. expansionary or tight fiscal policy

Question 15

What does Fine Tuning mean?

Answer 15

• This involves maintaining a steady rate of economic growth through using fiscal policy. However, this has proved quite difficult to achieve precisely.

Question 16

What is an Automatic Fiscal Stabiliser?

Answer 16

• 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 Taxes and lower Government spending will act as a check on AD.
• But, in a recession, the opposite will occur with tax revenue falling but increased government spending on benefits, this will help increase AD

Question 17

What are Discretionary Fiscal Stabilisers?

Answer 17

• This is a deliberate attempt by the government to affect AD and stabilise the economy, e.g. in a boom the government will increase taxes to reduce inflation.

Question 18

What is the Multiplier effect?

Answer 18

When an increase in injections causes a bigger final increase in Real GDP.

Question 19

What are Injections into an economy?

Answer 19

• This is an increase of expenditure in the circular flow, it includes govt spending(G), Exports (X) and Investment (I)

Question 20

What are Withdrawls in an economy?

Answer 20

• This is leakages from the circular flow This is household income that is not spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M)

Question 21

What criticisms are there of the Fiscal Policy?

Answer 21

• The government may have poor information about the state of the economy and struggle to have the best information about what the economy needs. (Lack of Information)
• Time lags. To increase government spending will take time. It could take several months for a government decision to filter through into the economy and actually affect AD. By then it may be too late. (Time Lags)
• Crowding out. Some economists argue that expansionary fiscal policy (higher government spending) will not increase AD because the higher government spending will crowd out the private sector. This is because the government have to borrow from the private sector who will then have lower funds for private investment (Crowding Out)
• Government spending is inefficient. Free market economists argue that higher government spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to reduce spending in the future because interest groups put political pressure on maintaining stimulus spending as permanent. (Government spending is inefficient)

Question 22

Evaluative points of the Fiscal Policy.

Answer 22

• It depends on the size of the multiplier. If the multiplier effect is large, then changes in government spending will have a bigger effect on overall demand.
• It depends on the state of the economy. Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand. In a deep recession (liquidity trap). Higher government spending will not cause crowding out because the private sector saving has increased substantially. See: Liquidity trap and fiscal policy – why fiscal policy is more important during a liquidity trap.
• It depends on other factors in the economy. For example, if the government pursue expansionary fiscal policy, but interest rates rise, and the global economy is in a recession, it may be insufficient to boost demand.
• Bond yields. If there is concern over the state of government finances, the government may not be able to borrow to finance fiscal policy. Countries in the Eurozone experienced this problem in the 2008-13 recession.