Fiscal policy

Question 1

Definition of fiscal policy

Answer 1

Fiscal policy 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

3 main purposes of Fiscal policy

Answer 2

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 3

What do gov’s use in conjunction with fiscal policy?

Answer 3

Fiscal policy is often used in conjunction with monetary policy. In fact, governments often prefer monetary policy for stabilising the economy.

Question 4

Describe expansionary (loose) fiscal policy

Answer 4

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 5

Graphically depict expansionary (loose) fiscal policy

Answer 5

Question 6

Describe conctractionary (tight) fiscal policy

Answer 6

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 7

Graphically depict conctractionary (tight) fiscal policy

Answer 7

Question 8

What type of fiscal policy did the UK government pursue in 2009?

Answer 8

In 2009, the government pursued expansionary fiscal policy. In response to a deep recession (GDP fell 6%) the government cut VAT in a bid to boost consumer spending.

This caused a big rise in government borrowing (2009-10). (Government borrowing also rose because of the recession leading to lower tax revenue)

Question 9

What did the new coalition gov of 2010 argue?

Answer 9

When the new coalition government came into power in May 2010, they argued the deficit was too high and then announced plans to reduce government borrowing. This involved spending limits.

These austerity measures were a factor in causing lower economic growth in 2011 and 2012

Question 10

Fiscal Stance:

Answer 10

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

Question 11

Fine Tuning:

Answer 11

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

Question 12

Automatic fiscal stabilisers:

Answer 12

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 T and lower G 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 13

Discretionary fiscal stabilisers:

Answer 13

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 14

The multiplier effect:

Answer 14

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

Question 15

Injections (J) –

Answer 15

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

Question 16

Withdrawals (W) –

Answer 16

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 17

1 Criticism of fiscal policy

Answer 17

The government may have poor information about the state of the economy and struggle to have the best information about what the economy needs.

Question 18

2 Criticism of fiscal policy

Answer 18

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.

Question 19

3 Criticism of fiscal policy

Answer 19

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.

Question 20

4 Criticism of Fiscal policy

Answer 20

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.

Question 21

5 Criticism of fiscal policy

Answer 21

Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments.

Question 22

1 The success of fiscal policy will depend on several factors, such as

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.

Question 23

2 The success of fiscal policy will depend on several factors, such as

Answer 23

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.

Question 24

3 The success of fiscal policy will depend on several factors, such as

Answer 24

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.

Question 25

4 The success of fiscal policy will depend on several factors, such as

Answer 25

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.

Question 26

Brief history of fiscal policy

Answer 26

Keynes advocated the use of fiscal policy as a way to stimulate economies during the great depression.

Fiscal Policy was particularly used in the 50s and 60s to stabilise economic cycles. These policies were broadly referred to as ‘Keynesian’

In the 1970s and 80s governments tended to prefer monetary policy for influencing the economy. Fiscal policy became more prominent during the great depression of 2008-13