25 - Fiscal policy

Question 1

Fiscal policy

Answer 1

The use of taxation and government expenditure policies to influence the level of economic activity to achieve the macroeconomic objectives (low unemployment, sustainable economic growth, low inflation (price stability)).
- demand side policy

Question 2

Sources of revenue for government

Answer 2

• Taxation
  
  • Tax refers to a government levy on income or expenditure. Taxes can be categorized as direct or indirect tax.
    
    • Direct tax
      
      • A type of tax levied on the income, wealth or profit of individuals and firms. (e.g. income tax, corporation tax, capital gains tax, inheritance tax, windfall tax)
    • Indirect tax
      
      • A type of tax levied on spending of goods and services in the economy. (e.g. sales tax (VAT or GST), excise duties, custom duties, stamp duty, carbon tax)
• The sales of goods and services from state-owned enterprises
• The sale of government assets / privatization

Question 3

Transfer payments

Answer 3

A sum of money from the government to another party for which no goods or services are being paid, there is no corresponding output or economic activity for such payments. (e.g. unemployment benefits (job seekers’ allowance), state pensions (for retirees), housing benefits, diability allowances, subsidy, etc.)

Question 4

Types of government expenditure

Answer 4

• Current expenditure
• Capital expenditure
• Transfer payments

Question 5

Expansionary fiscal policy

Answer 5

A demand-side policy used to stimulate the economy during an economic recession by increasing government expenditure (G), and lowering taxes to boost consumption (C) and investment (I). This helps to close a deflationary (recessionary) gap.

Question 6

Contractionary fiscal policy

Answer 6

A demand-side policy used to to reduce the level of of economic activity by decreasing government spending (G), and raising taxes to limit consumption (C) and investment (I). This is used to close an inflationary gap.

Question 7

Keynesian multiplier

Answer 7

The Keynesian multiplier shows that any increase in the value of injections (X, G, I) into the circular flow of an economy results in a proportionately larger increase in AD.

Question 8

Four determinants of the size of the multiplier effect

Answer 8

• Marginal propensity to consume (MPC)
• Marginal propensity to import (MPM)
• Margianl propensity to save (MPS)
• Marginal propensity to tax (MPT)

Question 9

Formulas to calculate Keynesian multiplier

Answer 9

• Keynesian multiplier = 1 / (1 - MPC)
• Keynesian multiplier = 1 / (MPS + MPT + MPM)
• Keynesian multiplier = 1 / MPW (MPW (marginal propensity to withdraw) = MPS + MPT + MPM)

Question 10

Constraints on FP

Answer 10

• Political pressure
• Time lags
• Sustainable debt
• Crowding out

Question 11

Crowding out

Answer 11

Crowding out occurs when increased governmnet borrowing (to finance its public sector spending) causes interest rates to rise, thereby reducing private sector investment expenditure.
- Hence, although government spending (G) increases, the consequential increase in interest rate causes private sector investment (I) to fall

Question 12

Strengths of FP

Answer 12

• Targeting of specific economic sectors
• Effective government spending in deep recession
• Automatic stablizers

Question 13

Automatic stablizers

Answer 13

Aspects of fiscal policy that naturally reduce fluctuations in the level of economic activity, thereby stablizing the rate of growth in real national output. Hence, automatic stablisers help to even out short-term fluctuations in the level of economic activity, as depicted in the business cycle.

Question 14

Two types of automatic stablizers

Answer 14

• Progressive tax
• Unemployment benefit

Question 15

A balanced budget

Answer 15

A government’s budget is in balance if its expenditures in a year equals its tax revenues for that year. A balanced budget will have no net effect on aggregate demand since the leakages (taxes collected) equal the injection (expenditures made).

Question 16

A budget surplus

Answer 16

If, in a year, the government collects MORE in taxes than it spends, the budget is in surplus. A surplus may sound like a good thing, but in fact the net effect of a budget surplus on AD is negative, since leakages exceed injections. A budget surplus will reduce the national debt.

Question 17

A budget deficit

Answer 17

If a government’s expenditure in a year a greater than the tax revenue it collects, the government’s budget is in deficit. A deficit has a positive net effect on AD, since injections exceed leakages from the government sector. A budget deficit will add to the national debt.

Question 18

The national debt

Answer 18

A nation’s debt is the sum of all its past deficit minus its past surpluses. If this number is negative, then it means the government has borrowed money over the years to finance its deficits that it
has not paid back through accumulated surpluses

Question 19

Fiscal policy and long-run economic growth

Answer 19

Infrastructure spending: When government supports a modern infrastructure, including for transportation and communications, the private sector is given the resources it needs to grow and succeed in the long-run.

Education spending: Public, government funded schools are programs to improve skills, and the labour can contribute to long-run growth.

Research and development: Government-funed research and development an lead to scientific, technological, and medical breakthroughs that may spur new industries and promote growth across the private sector.

(All shift LRAS curve or Keynesian curve to the right in the long run, therefore achieving economic growth (increase in potential output))