4.2.5 Flashcards
What is fiscal policy?
Fiscal Policy is where there are changes to government spending and taxation in order to influence AD.
Expansionary policy (increasing AD) can be used to boost growth, reduce unemployment, increase inflation and redistribute income.
Contractionary policy (reducing AD) is used to reduce inflation, reduce budget deficit/national debt, redistribute income and reduce the current account deficit.
Expansionary policy can both influence AD and LRAS, if the policy results in an increase in efficiency and investment. It can also lead to the multiplier effect.
Such policies could include:
-Reduction in income tax
-Reduction in corporate tax
-Increase in government spending
What are the issues with expansionary fiscal policy?
- Demand pull inflation
- Current account deficit
- Worsening of govt finances - Finances would need to be cut elsewhere or high taxes in the future
- Crowding out - when govt spending is heavily borrowing fuelled
- Time lags - changes in G and T takes time to take effect.
Fiscal Policy Eval
- Size of the output gap - Might only lead to inflation and little effect on growth or employment.
- Size of the multiplier - MPC
- Confidence
- State of govt finances
- LR returns to the govt - Increased G on education, healthcare and infrastructure could generate long term economic activity, resulting in high LR tax revenue.
- Laffer Curve ideas - Cutting taxes could lead to an increase in tax revenue
- Role of automatic stabilisers
What are automatic stabilisers?
Automatic stabilisers are fiscal policy tools to influence GDP and counter fluctuations in the economic cycle. They will automatically stabilise the economy during a boom and a recession.
For there to be an automatic stabiliser, an economy must have a progressive tax system and give welfare benefits.
In a boom, incomes will rise due to increased growth. This will push workers into higher tax brackets, increasing the average rate of tax, slowing down increases in consumption. Also, there will be low unemployment meaning that G on benefits will be low, reducing AD growth.
In a recession, incomes will fall resulting in workers being in lower tax brackets and the average rate of tax falling, preventing a large drop in C. Also, unemployment is high so G on benefits will increase, helping to increase AD.
What is crowding out?
Crowding out is an argument against the use of expansionary fiscal policy. This is where the government has to increase their borrowing in order to facilitate spending. In order to do this, they will sell bonds and demand more loanable funds. This increased demand will result in an increase in the interest rate which can then hold back investment and consumption and, thus, growth.
When has expansionary fiscal policy been used recently?
Fiscal Policy was used drastically during the pandemic. Some of the policies included:
-A blank cheque given to the NHS - Spend on hospitals, doctors, nurses, test and trace, vaccines and more
-Wages subsidies - furlough
-Increased G on welfare
-VAT Cuts
These policies had a clear aim to increase growth, inflation and reduce unemployment, through stimulating AD and bringing an economy out of recession.
However, these policies led to:
-Huge Budget Deficit - 14.5% of GDP in the fiscal year after Covid - Huge burden on future generations
-Demand pull inflation - Little deflation was seen during the pandemic/recession so the rising inflation was not a benefit
When has contractionary fiscal policy been used recently?
However, in order to deal with the outcome of covid, the government is now opting for contractionary fiscal policy. They have decided to use policies such as:
-An increase in national insurance
-An increase in corporation tax
-A rise in income tax through freezing tax brackets until 2026 - As workers earn higher wages in order to match inflation, they will pay higher taxes.
These taxes are put in place in an aim to reduce the enormous national debt and budget deficit. It also allows for flexibility to use expansionary policy during the next shock.
However, these policies are at risk of:
-Demand side shocks - Could put the economy back into recession
-Increased income inequality
What are supply side policies?
Supply Side Policies are those that aim to increase the productive capacity of the economy, shifting LRAS right.
Interventionist policies are where the government directly takes charge and will operate to reach a desirable outcome. Such policies include:
-Government spending on education and training - Boosts skills/qualifications of the workforce, boosting their productivity.
-Government spending on infrastructure - Improving the mobility of labour or long run costs of production of businesses will fall
-Subsidies for firms in order to promote investment - Improves capital which will be more productive
Market based policies aim to reduce government intervention. Such policies include:
-Lower income tax - provides an incentive to work
-Lower corporation tax - provides an incentive to invest
-Reduced welfare benefits - incentives to work
-Reduced minimum wages - reduced business costs, resulting in efficiency
-Reduced trade union power
-Privatisation - Aims to increase competition in a market and increase efficiency
-Deregulation - ‘’
-Trade Liberalisation - ‘’
What are the costs of supply side policies?
- There being no guarantee of success - E.g. firms may not use subsidies as desired
- High cost
- Time lag
- Policies need to be targeted to a specific issue
What are policies to increase growth?
To address SR growth, expansionary policy should be used, either fiscal or monetary.
-Demand pull inflation that is undesirable.
-State of govt finances
-Confidence
-Time lags
To address LR growth, supply side policies should be used, either interventionist or market based.
-No guarantee of success
-High cost
-Time lags
-Negative stakeholder impacts
Therefore, the policy that should be used to address an increase in growth would depend on the type of growth that is desired.
What are policies to reduce unemployment?
Cyclical unemployment occurs in a recession when AD is very low. To address this, AD must be stimulated through expansionary policy, either fiscal or monetary. However, there is a risk of demand pull inflation, state of government finances, reliance on confidence and time lags.
Real wage unemployment occurs when wages in the labour market are forced above equilibrium, resulting in an excess supply of labour and unemployment. To address this, wages must be brought down, with policies such as reducing minimum wages and TU power being adopted. However, there can be a negative impact on workers and an increase in inequality.
Structural unemployment is caused by the immobility of labour. Supply side policies can be used to resolve this immobility, such as increased govt spending on education/training and infrastructure. However, these policies have a high cost, time lags, no guarantee of success and negative stakeholder impacts.
Similarly, for frictional unemployment, supply side policies will be used.
What are policies to reduce inflation?
The target rate of inflation is 2% for the UK economy. Therefore, if inflation rises above this, policies may be used to reduce it closer to the target rate. The policy used will depend on the type of inflation.
For demand pull inflation, AD would need to fall to reduce inflation. This can be done through contractionary policy, either fiscal or monetary. However, it is more likely that monetary policy will be used due to inflation being a direct objective of the central bank and not the government. Therefore, it is likely an increase in interest rates will be enacted. However, this policy can lead to lower economic growth, higher unemployment, lower investment (reducing LR growth), impact on the indebted, strong exchange rate and current account deficit.
For cost push inflation, SRAS would need to rise, meaning there would need to be a fall in the costs of production. This could be through cutting taxes or giving subsidies to firms, although these would have negative effects for government finances.
For high long term inflation rates, supply side policies would need to be put in place, increasing LRAS and reducing price levels. However, there is no guarantee of success, high costs and time lags.
