Topic 4: Fiscal Policy Flashcards
(15 cards)
What is Fiscal Policy?
Fiscal Policy seeks to control aggregate demand by altering the balance between government expenditure (injection) and taxation (withdrawal).
– Excessive growth in aggregate demand can cause unsustainable short-term growth and higher rates of inflation
What are Automatic Stabilisers?
- Automatic stabilisers cause fiscal policy to be countercyclical by changing government spending or taxes automatically.
- Taxes and transfer payments [government expenditure] that stabilise GDP without requiring any action by the government.
- GDP = C + I + G + X – M [Known as Aggregate Demand (AD)]
What is Discretionary Policy and its three fiscal policy tools?
Discretionary fiscal policy is the government actively making a change to spending or taxes.
1. Changes in government spending (G) – current vs. capital expenditure
2. Changes to the taxation system – rates, thresholds etc.
3. Changes to transfer payments: payments by government to individuals or firms, including pension payments
and unemployment compensation.
What are Direct and Indirect Taxes?
– Direct Taxes: Levied on an individual/entity Examples: Income Tax,
Corporation tax, Property tax, viewed as Progressive Taxes
– Indirect Taxes: Levied on transactions irrespective of the
individual’s/entity’s characteristics i.e. ability to pay. Examples: VAT, customs & excise duties, viewed as Regressive Taxes
What Fiscal Policy Instruments are available to the government?
- Taxes – When policymakers change the taxes, the effect on aggregate demand is indirect—through the spending decisions of firms or households (through C + I).
- Government Spending - When the government alters its own purchases of goods or services, it increases or decreases aggregate demand directly (through G).
What is the difference between Expansionary Fiscal Policy and Contractionary Fiscal Policy?
Expansionary fiscal policy -
– Can be deployed in times of economic distress, e.g. a recession.
- Since expansionary fiscal policy involves raising government expenditure and/or lowering taxes, this has the effect of either increasing the budget deficit (government spending > government
revenue) or reducing the budget surplus.
Contractionary fiscal policy -
– Can be deployed in times of economic prosperity
- This involves raising taxes and/or reducing government expenditure as the economy begins to boom
What are the five stages of the business cycle, and what are the features, causes and policy responses
- Recession: Features include falling income, high unemployment and low tax. Causes include Fall in AD: C+I+G+(X-M). The Policy Responses are Raise AD(Aggregate Demand) – expansionary policy:
Reduce tax, Raise public expenditure, Lower interest rate - Trough: Slight more recovered but still similar effects. Cause is still Fall in AD: C+I+G+(X-M). Policy response still Raise AD.
- Stagflation: economy is still falling, though not as rapidly, inflation begins to rise. Causes are Reduction in Aggregate Supply (AS). Low AD combined with imported cost push inflation. Policy response is Raise AS: Supply-side policies
- Recovery(expansion): Economy has recovered, rising income, falling unemployment, moderate inflation. Causes are return of confidence and expansionary policy taken during recession. However, now policy is to reduce expansionary policy
- Boom(peak): Economy thriving, higher output, employment, gov income. Inflation rising due to demand pull. Cause is Rise in AD:
C+I+G+(X-M). Policy response is to decrease AD by raising taxes and reducing public expenditure
What is the Marginal Propensity to Consume (MPC) and how to calculate it?
Marginal Propensity to Consume is the proportion of an increase in income that is spent on consumption.
MPC varies by income level: MPC is typically lower at higher incomes (more needs and wants satisfied so more likely to save). MPC is higher at lower incomes.
MPC is the key determinant of the multiplier, which describes the effect of increased government spending as an economic stimulus.
* Marginal Propensity to Consume (MPC): Change in consumption
Change in income
What is the Government Spending Multiplier and how to calculate it?
- The government expenditure multiplier is the quantitative effect of a change in government expenditure on real GDP
- Because government expenditure (G) is a component of aggregate demand (AD), an increase in government expenditure increases real GDP.
K = 1 = 1 .
1-MPC MPS
MPC = Marginal propensity to consume
MPS = Marginal propensity to save
What is The Model of Aggregate Demand (AD) and Aggregate Supply (AS)?
- The paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilise the economy
- Shows how the price level and aggregate output are determined.
- Shows how the economy’s behaviour is different in the short run and in the long run.
Key Difference between short-run and long-run in Economics? - Behaviour of prices - In the long run – prices are flexible and respond to changes in demand/supply.
- In the short run – prices are ‘sticky’ at some predetermined level
Explain Aggregate Demand (AD) Curve?
Price Level- y curve, Real output- x curve
- An increase in the price level causes a decrease in the demand for goods and services.
- Shifts to right when Consumption, Investment, Government increases, greater quantity demanded. Other factors can be loan creation, higher interest rates and consumer confidence
- Shifts to left when CIG decreases, lower quantity demanded. Other factors are price inflation, lower interest rates and consumer confidence.
Explain Aggregate Supply (AS) Curve?
-An increase in the price level causes an increase in the supply
of goods and services
- Shifts right when costs of inputs decreases and government increases business subsidies and decreases business taxes.
- Shifts left when costs increase, gov policy decrease subsidies and increase taxes. Outside factors e.g. natural disasters and trade tensions.
What is Equilbrium?
Aggregate demand (AD) curve intersects with aggregate supply (AS).
Total demand equals total supply within an economy
The model can show how inflation and unemployment might arise in an economy and how a government might respond to these problems.
What is the SGP?
The Stability and Growth Pact (SGP) is a set of rules designed to ensure that countries in the European Union pursue sound public finances and coordinate their fiscal policies
Budget deficit to GDP: maximum 3% (deficit does not exceed 3% of GDP)
Debt to GDP ratio: maximum 60% (or if above: declining towards 60%)
What are the problems with Fiscal Policy?
Inside lags: delays that occur within the government four major types: A data lag, A recognition lag, A legislative lag. A transition lag.
Outside lags are delayed effects of government policies
1. Long & variable lags, inside lag: takes time to recognise shock and to implement policy, especially fiscal policy.
outside lag: the time it takes for policy to affect economy
- If conditions change before policy’s impact is felt, then policy may end up destabilising the economy.
2. Political problems: Other economic goals, economic growth complements and conflicts with other policies
- Expansionary bias, often used to stimulate rather than slow the economy
