15) Fiscal Policy - Effectiveness (2)

Question 1

Which policies are demand or supply side policies?

Answer 1

Both fiscal and monetary are demand-based, ie their objective is to influence AD, normally (though not always) looking to shift it to the right

Question 2

What is the aim of supply side policies?

Answer 2

Aim to shift AS to the right, in particular LRAS

Question 3

What is the type of diagram called where AD slopes downwards left to right, SRAS slopes upwards left to right whilst LRAS is perfectly inelastic at point Yfe?

Answer 3

Neo-classical approach

Question 4

When is fiscal policy most effective?

Answer 4

Dealing with a deep recession

Question 5

When is expansionary fiscal policy dangerous?

Answer 5

If the economy is close to (or at) Yfe, expansionary fiscal policy is dangerous and inappropriate

Question 6

What happens to the AS curve in the Keynesian diagram?

Answer 6

• we merge SRAS and LRAS into one line, labelled AS

Question 7

How do you draw the horizontal (perfectly elastic) part of the AS curve?

Answer 7

Starting from point PL1 and extending about half way across the Y axis

Question 8

How do you draw the upward sloping section?

Answer 8

At the end of the horizontal, start an upward sloping section, this could be diagonal (like SRAS) but looks better as gentle, slightly curved line about another 20% of the way along the Y axis

Question 9

What do you draw after the sloping section?

Answer 9

Draw a vertical section to finish the curve - this is Yfe

Question 10

What are the differences in the Keynesian diagram with the Neo-classical approach?

Answer 10

Keynes insists that at low levels of Y, where the economy is in a deep recession, PL is stuck at PL1 and won’t go below PL1

Question 11

What are “sticky prices”?

Answer 11

Keynes insists that at low levels of Y, where the economy is in a deep recession, PL is stuck at PL1 and won’t go below PL1, the prices of the factors of production (eg wages) and goods and services have a minimum level below which workers are unwilling to offer labour and businesses are unwilling to sell goods and services

Question 12

What does AD1, along the horizontal show?

Answer 12

Shows AD at a very low level of Y (Y1)

Question 13

What does the size between Y1 (where AD1 is along the horizontal) Yfe show?

Answer 13

There’s a large NOG (Yfe-Y1), representing mass unemployment of the factors of production

Question 14

When there is a NOG, what does Keynes argue?

Answer 14

That at this point the government could and should engage in expansionary fiscal policy, increasing AD from AD1 to AD2, increasing Y to Y2, reducing the NOG to Yfe-Y2 whilst crucially not increasing PL

Question 15

Why does the Price Level not increase as AD1 shifts to AD2 (both are among the horizontal AS)?

Answer 15

This is because all the extra AD can be absorbed by existing spare capacity in the economy

Question 16

Further increases in AD, what will it do to the NOG?

Answer 16

Will reduce and ultimately eliminate the NOG but at the expense of higher PL (inflation)

Question 17

What will be the result of AD4 shifts to AD5 (both are along the vertical AS)

Answer 17

Policies aimed at expanding AD4 to AD5 will be futile, increased AD leading to higher inflation but with no increase in Y

Question 18

When is expansionary fiscal policy less effective on the diagram?

Answer 18

After Y2 (when AD is on the horizontal) the closer that the economy moves, the less effective expansionary FP

Question 19

What could do the government do at AD5? (The highest point along the vertical)

Answer 19

The government could justifiably use deflationary fiscal policy to reduce the PL but still remain at Yfe