A2 The Operation of Fiscal and Monetary Policy Flashcards
What is fiscal policy?
Policy measures that affect the governments expenditure and revenue through decisions made by the government on expenditure, taxation and borrowing.
This is done to ultimately influence the level of aggregate demand in an economy
What is monetary policy?
The use of monetary variables such as money supply and interest rates to influence the level of Aggregate demand in an economy.
What are supply-side policies?
These are policies that are designed to affect aggregate supply directly, influencing the potential capacity output of the economy.
What is a budget deficit?
When government expenditure exceeds government revenue.
What is a balanced budget?
A neutral government budget is when government expenditures are equal to revenues. This can be achieved by high expenditure and revenues or low E and R.
What is a budget surplus?
When government expenditure is less than revenues.
What is meant by direct taxation?
These are taxes that are levied on certain types of income e.g. personal income tax
What are indirect taxes?
Taxes that are on expenditure e.g. VAT and excise duties.
Why are direct taxes sometimes seen as being fairer to society in comparison to indirect?
Direct taxes are progressive and can help in the redistribution of income while effectively indirect taxes are regressive as taxes on petrol are likely to take up a higher proportion of a poor persons income than a rich.
Why does a budget deficit create fiscal unsustainability?
When the government spends more than what it has received in taxation receipts, this spending must be funded by government borrowing. This means future generations will have to pay for past government expenditure through the proportion of their taxes that is used to fund government debt incurred from borrowing.
What is the “Golden Rule of Fiscal Policy”
Established by the Labour government from 1997-2010, this rule stated that on average over the economic cycle the government should only borrow for investment purposes , but not to fund current expenditure. This would reduce the degree to which future generations would have to pay for the expenditure of past generations.
How effective was the “Golden Rule of Fiscal Policy?”
It had limited success as it was a self-imposed guideline by the government, rather than a separate body making sure that this rule was followed. This meant there was no real penalty to breaking the rule, other than a loss of credibility.
Since it was formed by the Labour government, the Conservative government have proven to be less committed to following the rule.
This rule can be especially difficult to follow if there is an economic event- following the 2008 Financial crisis the need to bail out commercial banks meant keeping to this rule was impossible.
What is a key Fiscal rule relating to the level of public sector debt?
There was a commitment to keep public sector net debt below 40% of GDP, on AVERAGE over the economic cycle.
How effective was the government debt level fiscal rule?
It may be difficult to manage during a turbulent economic event and did not survive during the 2008 financial crash as government net debt rose to 140% of GDP in 2008 as the government borrowed money to bail out banks as well as their decision to cut VAT (an indirect tax) from 17.5% to 15% to encourage consumer expenditure.
Describe two fiscal rules
“Golden Rule of Fiscal Policy”-on average over the economic cycle the government should only borrow for investment purposes , but not to fund current expenditure. This would reduce the degree to which future generations would have to pay for the expenditure of past generations.
Level of public sector debt- There was a commitment to keep public sector net debt below 40% of GDP, on AVERAGE ( not necessarily constantly) over the economic cycle.
What is the effect of an increase in the budget surplus on the AD curve.
Since government revenues from taxes exceed spending to a further degree this shifts AD to the left.
-an increase in taxes are a leak from the circular flow of income and increase the marginal propensity to withdraw, weakening the multiplier effect if there is an increase in spending in the economy..
-A budget surplus could cause a negative multiplier effect especially if this budget surplus is reached through austerity, reduced government spending shifts AD to the left as this is a component of AD.
What is crowding out?
When an increase in government expenditure pushes out private sector activity by raising the cost of borrowing
What can bring about crowding out?
If the government is running a large budget deficit it will fund the excess spending by borrowing. This puts upward pressure on interest rates as when borrowing increases interest rates do too (think supply and demand).
Because the cost of borrowing has increased consumers are less likely to take out loans and mortgages.
Firms are less likely to take out loans for investment, reducing private sector activity due to government spending.
What is crowding in?
A process by which a decrease in government expenditure encourages private sector activity by lowering the cost of borrowing.
What can bring about crowding in?
If the government run a budget surplus the government can use the excess revenue to fund the government debt, reducing its need for borrowing.
This puts downward pressure on interest rates, reducing the cost of borrowing, impacting firms and consumers.
Does an increase in the budget deficit always mean that AD will shift to the right?
The extent of the shift can be reduced if it ‘crowds out’ the private sector, through raising the cost of borrowing. This will mean in terms of the firm and consumer components of AD, AD will fall.
Does an increase in the budget surplus always mean that AD will decrease?
The extent of the shift is dependant on whether the decrease in government expenditure ‘crowds in’ private sector activity. A reduction in gov. expenditure could result in downward pressure on interest rates, reducing the cost of borrowing and so increasing firm and consumer expenditure. This could happen to such an extent to where it makes up for the reduction in aggregate demand that arose from the governments reduction in spending. Causing AD to actually increase due to a budget surplus.
What is an automatic stabiliser?
Government spending and revenues that vary automatically with the economic cycle, in order to stabilise the economy, this is not done with conscious effort from the government.
E.g. in the time of a recession government expenditure will rise because of the increased payments of unemployment benefits as well as receipts will fall as less people are paying income tax and less people are buying so VAT receipts will fall.
What is discretionary fiscal policy?
A contrast to automatic stabilisers, discretionary fiscal policy is when the government deliberately try to influence the economy
How might discretionary policy be used to improve macroeconomic performance.
The government may actively intervene with fiscal policy (gov spending, tax, borrowing) in order to increase real output to bring the economy closer to the level of full employment.
However, this will only work depending on how much spare capacity the economy has, monetarists believed the supply curve was vertical so an increase in AD will only impact the price level. Hyper-inflation was experienced by quite a few Latin American countries in the 1980s resulting a reduction in investment and lower productive capacity (AS shifts to the left)
What is an argument for privatisation?
Managers in the public sector may not feel responsible for their actions, which could cause x-inefficiency to become an issue meaning public sector enterprise is less efficient than private. So public sector enterprise could lower productive capacity more than what is necessary.
Why is discretionary fiscal policy sometimes necessary?
Government intervention is often necessary to correct market failure, for example excise duties to limit the consumption of demerit goods with negative externalities, or spending to make sure that public goods (e.g. street lights) are provided for.
Explain the role for fiscal policy in terms of income distribution?
The government must find the right balance between direct and indirect taxes as issuing more indirect taxes (e.g. VAT) will increase inequality as they are often more regressive towards people on lower incomes.
At the same time direct taxes with a high marginal tax rate can result in people becoming De-incentivized from working harder to get a higher income as they know a large portion will be taxed away.
