Discretionary Fiscal Policy Flashcards
Expansionary Fiscal Policy
A policy that increases AD and shifts the AD curve to the right. This is done through increasing Government Expenditure and/or Lowering Tax rates.
How EFP works
Increase in Government Expenditure: G is a component of AD, an increase in G will raise AD. (Give example of expenditure) Leading to an increase in AD>
Decrease in Taxes:
Personal income tax decreases, which increases disposable income , and thus consumers increase their spending on goods and services resulting in an increase in C and thus AD.
Corporate Income tax decreases, firms’ after tax profits increases. This induces them to utilise higher profits for more investment projects thus increasing AD.
Contractionary Fiscal Policy
A policy that decreases AD and shifts the AD curve to the left. This is done through decreasing Government Expenditure and/or Increasing Tax rates.
Non-Discretionary Fiscal Policy/ Automatic Fiscal Stabilisers
Features of the tax system and government spending that reduce the economy’s cyclical fluctuations, without the need for conscious government policy decisions.
How automatic fiscal stabilisers work
They merely reduce the magnitude of fluctuations of AD.
Tax structure as stabiliser: Income tax structure can be a stabiliser when there is an increase in AD. In the case of progressive income tax structure, tax yield will rise faster than income. This increase in taxes will reduce the rate of increase of disposable incomes and thus lower the growth of consumption expenditure, which partially offsets the initial de-stabilising increase in AD.
Transfer payments as stabiliser: Transfer payments can be a stabiliser when there is a decrease in AD. With a fall in national income and rising unemployment, transfer payments will increase. This will increase Household’s disposable income, which in turn increases AD. The resulting rise in AD will partially offset the initial de-stabilising decrease in AD.
Limitations of Fiscal Policy: Size of multiplier
Impact of fiscal policy depends on the multiplier effect. Increases in Government spending may stimulate further spending by households, hence helping to amplify the effects of fiscal policy on national income, output and employment. If the size of the multiplier is small, national income , output, employment will not increase as much as desired.
Governments also do not know the precise value of the multiplier, it is difficult to fine tune the economy accurately. This may result in over/under spending, which can be further detrimental to the economy.
Limitations of Fiscal Policy: Crowding out effect
Crowding out effect occurs when an increase in government spending due to an EFP reducing other types of spending by firms and consumers, such that overall AD does not increase at all or in a limited way.
Increase in Government Spending might take up scarce fixed pool of loanable funds, interest rates may be driven up. The higher cost of borrowing loans reduces borrowing by firms/households leading to reduced investment spending and consumer spending. This dampens the expansionary effect of the initial rise in Government Expenditure on the economy.
