3.6 Demand Side Policy - Fiscal Policy Flashcards
Sources of government revenue
- Taxes (both direct and indirect)
- Sales of goods and services - e.x transport, electricity, water
- From sale of government-owned assets or property (privatization)
Types of government expenditure
current expenditures - include government spending on day-to-day items e.x wages and salaries, spending for supplies for day-to-day operations
capital expenditures - include public investments or spending to produce physical capital e.x roads, airports, school buildings, hospitals
transfer payments - payments by government to vulnerable groups to redistribute income e.x unemployment benefits, child allowance
What is fiscal policy
Changes in taxation and government spending in order to manipulate/influence AD levels
What are the goals for fiscal policy
- low and stable rate of inflation
- low unemployment
- reduce business cycle fluctuations
- promote stable economic environment for long-term
- external balance (country’s revenues from exports roughly equal to imports)
- equal distribution of income
What is expansionary fiscal policy
The increase in government spending and reducation of taxation in order to stimulate economy and increase AD
What is contractionary fiscal policy
The decrease in government spending and increase in taxation in order to decrease AD
Fiscal policy used to correct deflationary gap + graph for it
Expansionary fiscal policy:
- increase goverment spending + decrease personal income taxes and business taxes
- increase in government spending, directly impact AD, shifting it outwards
- cut in income tax causes a rise in disposable income, increase in spending, AD curve shifts to the right correcting the deflationary gap
- cut im business tax, increases profits, lead to higher investment spending, AD curve shifts to the right correcting the deflationary gap
Fiscal policy to correct inflationary gap + graph for it
Contractionary fiscal policy:
- decrease government spending + increase personal income and business tax
- decrease goverment spending, direct influence on AD, causing it to shift leftward
- increase in income tax causes a fall in disposable income, decreasing spending, AD curve shifts to the left correcting the inflationary gap
- increase in business tax, decreases profits, lead to lower investment spending, AD curve shifts to the left correcting the inflationary gap
Constraints of fiscal policy
time lags - time taken to decide on a appropriate policy and policies may take months to take effect into economy, problem may have become more or less severe
political constraints - GS and taxation face political pressure - may result to unsuitable fiscal policy due to pressure
sustainable debt - deficits arise when government spending is more then revenues - over extended period of these may lead to unsustainable debt
may be ineffective in deep recession - tax cuts are less effective in recession compared to increases in government spending - consumers may turn to saving the increase income after tax due to pessimism about future
crowding out - government borrowing increases demand for money, increasing interest rate - lead to lower investment spending by firms, weakening governments expansionary fiscal policy
Explain crowding out and the graph
Occurs in expansionary fiscal policy:
- increases in government spending means government must borrow money
- involves an increase in demand for money
- leads to increase interest rate
- high interest rate increases cost of borrowing, decreasing investment spending by private firms
- AD shifts rightward due to government spending
- but then shifts slightly leftwards due to reduction in investment
What are the strengths of fiscal policy
Pulling economy out of deep recession
Ability to target sectors of the economy - may change amount of spending in the economy, focusing on on specific sectors
Direct impact of government spending on AD - changes in government spending are direct and certain to change AD
Effective with rapid and escalating inflation
Automatic stabilizers - help stabilize Econ,y by reducing short-term fluctuations of business cycle
Explain automatic stabilizers + graph for it
Are factors that automatically, without any action by goverment, work towards stabilizing the economy
2 stabilizers:
Progressive income tax:
- more progressive income tax system, the greater the stabilizing effect
- in recession with real GDP falling, individuals’ incomes tend to decrease
- resulting in lower tax payments which leave more money in the hands of consumers, AD falls less, making recession less severe
Unemployment benefits:
- in recession as real GDP falls, unemployment increases
- leading to greater spending on unemployment benefits
- allowing for the unemployed to somewhat maintain their consumption
- also increases goverment spending, lessening the downward pressure of AD
What is the Keynesian multiplier + froumula
Explanation for why the final increase in real GDP is greater than the initial increase in expenditure
Multiplier = (Change in Real GDP)/(initial change in expenditure)
Or
1 / (1-MPC)
Or
1 / (MPS + MPT + MPM)
What is MPC
Marginal propensity to consume — the fraction of additional income that households spend on consumption of domestically produced foods and services
What is MPS
Marginal propensity to save — fraction of income saved
