Fiscal Policy

Question 1

Who manages the fiscal policy?

Answer 1

The UK government

Question 2

Define the fiscal policy

Answer 2

Fiscal policy aims to stimulate economic growth and stabilise the economy by changing the government spending and taxes to influence the size of the circular flow of income

Question 3

Define expansionary/loose fiscal policy

Answer 3

The government increase government spending or lowers taxes to expand the economy which worsens the budget deficit as government spend more and receive less tax revenue

Question 4

Define contractionary/tight fiscal policy

Answer 4

The government decrease government spending or increase taxes to improve the budget deficit as the circular flow of income contracts and they receive higher tax revenue

Question 5

High income tax effect on high earners

Answer 5

Raising the income tax rate for high earners decreases their disposable income. This will decrease consumption and aggregate demand, which will help to bring the price level down and control inflation. Also, a higher income tax rate will increase income tax revenue and help the government to balance its budget.

However, a reduction in aggregate demand will reduce real GDP. Also, an increase in income tax may increase tax evasion and avoidance which could even mean that income tax revenue decreases.

Question 6

Define real GDP (2 marks)

Answer 6

Real GDP refers to gross domestic product which is the total of all goods and services produced over a given period of time (annually) , adjusted for the effects of inflation; that is in ‘real terms’

Question 7

Pros and Cons of Higher Benefits

Answer 7

Pros

• More money transferred to unemployed workers - increase their consumption, increases AD
• Help to reduce income inequality.

Cons

• Benefits trap - If benefits are too high, there is a significant disincentive for unemployed people to find a job, because they may earn more by claiming benefits.

Question 8

Pros and Cons of Lower Benefits

Answer 8

Pros

• Budget deficit will improve as the government is paying out less
• May get the unemployed out of the benefits trap by increasing the incentive to work - this will reduce unemployment.

Cons

• Poor households will have less to spend, so consumption will fall, which will decrease AD
• Income inequality will worsen as the poor get poorer.

Question 9

Pros and cons of increasing corporation tax

Answer 9

Pros

• Increase tax revenue for the government, helping to improve the budget
• The increased tax revenue could be used to increase government spending, which will lead to economic growth.

Cons

• Firms make less profit and are likely to reduce their investment in capital, which causes depreciation in productivity. This makes them less productive and reduces LRAS

Question 10

Pros and Cons of decreasing corporation tax

Answer 10

Pros

• Lower costs for firms. This will shift SRAS to the right and increase real GDP in the short run.
• Firms can keep more of their profit, so they are likely to increase investment, which will increase AD. Increasing investment will increase the productivity of capital and shift LRAS to the right, leading to economic growth.

Cons

• Government will receive less tax revenue
• The extra profit from reducing corporation tax might just be kept by the owners instead of being used for investment.

Question 11

Higher VAT pros and cons

Answer 11

Pros

• Increase tax revenue for the government, which will improve the budget deficit

Cons

• Increase costs for firms, which will shift SRAS inwards. This can reduce economic growth and leads to cost push inflation.

Question 12

Pros and cons of Lower VAT

Answer 12

Pros

• Decrease costs for firms, which will increase SRAS. This will increase real GDP and economic growth, and also bring the price level down.

Cons

• Decrease tax revenue and worsen the budget deficit.

Question 13

Pros and Cons of Increased Healthcare and Education Spending due to increase in government spending

Answer 13

Pros

• Increase on government spending increases aggregate demand and, therefore, real GDP
• Will make the workforce healthier and more productive, so the LRAS will shift right

Cons

• Worsen the government’s budget deficit
• Spending on schools and education could go towards unproductive bureaucracy or useless degrees

Question 14

Pros and Cons of Decreased Healthcare and Education due to cut in government spending

Answer 14

Pros

• A cut in university subsidies means more students are forced to enter the labour market instead of going to university. This increases the supply of labour so wages decrease. So firms costs decrease and they are able to produce more which shifts SRAS outwards - this is a supply-side effect

Cons

• If university subsides are cut, workers will lack the skills required in the future for specific jobs, which will decrease productivity and shift SRAS in
• Lower government spending on the NHS may decrease efficiency meaning illnesses go untreated which will decrease worker productivity, decreasing real GDP and AD, as a result decreasing long-run economic growth

Question 15

What is infrastructure?

Answer 15

Items needed for businesses to operate such as roads and telecommunications networks.

Question 16

Limitations of fiscal policy

Answer 16

o Governments might have imperfect information about the economy. It could
lead to inefficient spending

o There is a significant time lag involved with employing fiscal policy. It could
take months or years to have an effect.

o If the government borrows from the private sector, there are fewer funds
available for the private sector, which could lead to crowding out.

o The bigger the size of the multiplier, the bigger the effect on AD and the
more effective the policy.

o If interest rates are high, fiscal policy might not be effective for increasing
demand.

o If the government spends too much, there could be difficulties paying back
the debt, which could make it difficult to borrow in the future.

Question 17

Define budget deficit
Define budget surplus

Answer 17

A government has a budget deficit when expenditure exceeds tax receipts in a
financial year.
A government has a budget surplus when tax receipts exceed expenditure.