Week 21 - Chapter 25: Fiscal Policy

Question 1

Stabilisation policies

Answer 1

Government policies used to affect PAE to eliminate output gaps.

Question 2

Expansionary and contractionary policies

Answer 2

• Expansionary policies: increase planned expenditure.
• Contractionary policies: decrease planned expenditure.

Question 3

What are the two major tools of stabilisation policies

Answer 3

• Fiscal policies: policies which use changes to the government budget - government spending, transfers or taxes.
• Monetary policies: policies which use changes to the money supply.

Question 4

How does fiscal policy affect PAE

Answer 4

Government spending has a direct effect on PAE and taxation and transfer payments have indirect effects on PAE.

Question 5

Crowding out effect

Answer 5

• The tendency of an increase in government expenditure to increase the rate of interest, and reduce consumption and investment by the private sector.
• Occurs when PAE is affected by changes in interest rates like government borrowing.
  E.g., government borrowing to fund expenditure -> increased demand for loans causes higher interest rates -> higher interest rates means borrowing is more expensive for consumers and firms -> consumption and investment decreases.

Question 6

What does the strength of the crowding out effect depend on

Answer 6

• The responsiveness of consumption and investment to interest rate changes.
• The responsiveness of the demand for money to interest rate changes.

Question 7

How is PAE affected by taxation and transfer payments

Answer 7

It is effected indirectly through consumption and the effects on disposable income.
Lower taxes or higher transfer payments increases disposable income which increases consumption which increases PAE.

Question 8

How does fiscal policy affect potential output (Y*)

Answer 8

• Investment in infrastructure increases Y*
• Taxes and transfers affect incentives and can change Y*
  Tax cuts increases and transfers incentivise people to spend more - increases C.

Question 9

Limits of using fiscal policy

Answer 9

• Expansionary policy increases government spending which increases the government deficit.
  If expansionary policy is persistently used, national savings will be decreased which reduces investment and therefore growth.
• If government deficit is already high, expansionary policy may not be able to be used as there is no money available to spend.
• Political considerations make it difficult to use contractionary fiscal policy - people prefer to consume more than consume less, hard to get elected if you say you are going to use contractionary fiscal policy, even if it would help in the long run.

Question 10

Limits of fiscal policy flexibility

Answer 10

• Legislative process requires time meaning change to fiscal policy can be slow
• Competing political objectives like national defence or income support which may have different spending objectives compared to what is best for the economy.

Question 11

Discretionary fiscal policy

Answer 11

Decisions made by the government to change government spending through purchases, taxation or transfer payments.

Question 12

Non-discretionary fiscal policy/ automatic stabilisers

Answer 12

Changes of government budget deficit (G-T) that is built into laws. No legislation needs to be passed for non-discretionary fiscal policy to be used so it is faster than discretionary fiscal policy.

Question 13

How do automatic stabilisers work in recessions and expansions

Answer 13

• Recessions: Income, consumption and profits decline -> more people claim unemployment benefits -> less tax revenue, less consumption, less profit taxes, increased transfer payments.
  Net taxes have automatically decreased.
• Expansions: Income, consumption and profits increase -> less people claim unemployment benefits -> more tax revenue, more consumption, more profit taxes, decreased transfer payments.
  Net taxes have automatically increased.