Fiscal Policy Flashcards
(26 cards)
Define Fiscal Policy
Manipulation of government spending and taxation in order to influence aggregate demand in the economy and achieve macroeconomic aims
What is Expansionary Fiscal Policy?
When the government reduces the level of taxation and increases government spending to increase aggregate demand
Why might the government use Expansionary Fiscal Policy?
- Boost Economic Growth
- Reduce Unemployment
- Influence Inflation Rates
- Redistrubute Income [welfare benefits, regressive tax]
What is Contractionary Fiscal Policy?
When the government increases the level of taxation and reduces the amount of government spending in order to lower aggregate demand
Why might the government use Contractionary Fiscal Policy?
- Reduce Demand-Pull Inflation
- Correct a Current Account Deficit
- Reduce Budget Deficit / National Debt
- Redistrubute Income [Progressive Taxation]
How does Expansionary Fiscal Policy increase aggregate demand?
- Increased injections through government spending or lowered taxation, widening of tax bands [can be specific] can increase disposable incomes and profits after tax
- This can increase the marginal propensity to consume and invest
- Which leads to increased spending on goods and services and investment in the economy
- Which increases consumption and investment in the AD equation
How does the Multiplier Effect influence aggregate demand?
A direct injection, such as government spending can inject additional demand in the economy which will have a magnified effect on output, income and employment due to the positive contribution of the multiplier effect which makes the final outcomes of spending and AD higher
What is a side effect of Expansionary Fiscal Policy?
An increase in LRAS.
This is because reductions in income tax can incentivise the inactive to rejoin the labour force which increases quantity of labour and productivity of labour, boosting LRAS. Similarly, improvements in productive efficiency through capital investment can help exploit economies of scale and boost LRAS.
What are the limitations of Expansionary Fiscal Policy?
- Trade-off between other macro-objectives, such as demand-pull inflation and current account deficit
- Crowding Out Effect
- Worsening of government finances
- Time lags [recognition of the problem, implementation, reactions]
What is meant by Crowing Out?
The government may borrow money in order to fund the expansionary fiscal policy and budget deficit, which could increase the demand for loanable funds, pushing up equillibrium interest rates of loanable funds in the economy, which makes it difficult for the private sector to fund investment, affecting long term growth and over reliance on govt. spending to boost economic growth.
What is meant by worsening of government finances?
The budget deficit rises, national debt can increase and It can questioned where the government is funding the increased spending - if it means cuts to spending in other areas it could harm the welfare of some people. Similarly, consumers could anticipate higher taxation in the future, which could reinforce the Ricardian Equivalence during expansionary fiscal policy.
Explain Ricardian Equivalence
The government cannot afford expansionary fiscal policy in the long term, due to increased debt interest / budget deficit, which is unproductive government spending. This could cause households to anticipate future tax rises and save tax cuts during expansionary fiscal policy.
Explain some points about the time lag
- It could take time for the government to identify and assess the problem, implement the policy and for economic agents to react.
- Projects such as infrastructure can take rounds of government spending - this could act to reinforce the business cycle given that by the time the project is completed, contractionary fiscal policy might be required due to a positive output gap or inflationary pressures, especially if the multiplier effect is more profound.
What are some Evaluative Points to consider about the effectiveness of Expansionary Fiscal Policy?
- Size of the Output Gap [Where is the economy in term of actual growth/potential growth, spare capacity? - may not cause inflation]
- Size of the Multiplier [may indicate whether large fiscal policies are needed]
- Consumer and Business Confidence [Ricardian Equivalence]
- Crowding out vs Crowding in
- Laffer Curve Arguments [Incentivising]
- Role of Automatic Stabilisers
Explain Crowding In
Keynesians argued the risk of crowding out is very low in a recession because there are increased savings through the liquidity preference theory, which lowers the chance of pushing up equilibrium interest rates. An expansionary fiscal policy creating demand, generating economic activity could incentivise the private sector to invest in growth due to greater profit potentials.
What is the Role of Automatic Stabilisers in a Boom?
Automatic fiscal policy tools which affects the business cycle. For example, during a boom, the economy is rampant in growth, and those in work may be pushed into higher tax bands. Through progressive taxation, this would increase the ART and slow down consumption and control the extent of the boom and increases in AD.
What is the Role of Automatic Stabilisers in a Recession?
Economic growth rates are negative and incomes are moved into lower tax bands, as workers are not earning as much. This reduces the ART and prevents large decreases in consumption, which reduces the length of falling AD and keep output up to a certain level, preventing a deeper recession.
What are the advantages of Contractionary Fiscal Policy?
- Confidence in Government Finances
- Greater Flexibility with Fiscal Policy
- Less Crowding Out
- Lower Inflation and Current Account Deficit
Explain Confidence in Government Finances
By reducing budget deficits and national debts, it promotes greater confidence, which translates into improved credit ratings on government bonds - as they are seen as less risky borrowers. Overtime, this could lead to lower interest rates making it cheaper for the government to borrow and fund public investments.
Can also attract inward FDI
Explain Greater Flexibility
If budget surpluses are being run, governments may be operating under their fiscal rules, which allows space for fiscal policy whenever required. Similarly, there is lesser spending on debt interest, which leads to sustainable finances and affordability.
Explain Lower Inflation and Current Account Deficit
Lower aggregate demand and higher taxation means lower incomes and the marginal propensity to spend, which reduces demand pull inflation and spending on imports
What are the problems with Contractionary Fiscal Policy?
- Demand Side Shock
- Micro and Macro Impacts
- LR returns ignored
- Distortion of Incentives - Laffer Curve Argument
- Risk of Income Inequality
Explain Demand Side Shock
If the policy is used very strongly, it can shock the economy into a recession by reducing AD, leading to lower growth and higher unemployment
Explain Micro and Macro Impacts
By cutting govt. spending, it can reduce quality and quantity of public services, which can affect individuals and harm living standards. Increases taxation can harm investment and long run productive potential, constrainting LRAS.
Those who rely on public spending, like education or healthcare
