Fiscal Policy

Question 1

Define Fiscal Policy

Answer 1

The government making changes to the levels of taxation and government spending in order to influence aggregate demand (AD) and the level of economic activity.

Question 2

What are the 3 aims of fiscal policy?

Answer 2

• Stimulate economic growth in a period of a recession
• Keep inflation low (UK gov target of 2%)
• Stabilise economic growth, avoiding a booms and downturns in the economic cycle.

Question 3

What is expansionary fiscal policy and what does it do to the budget?

Answer 3

Increases AD

• lowering tax -> increased disposable incomes and so increased consumption
• increasing government spending
• worsens the budget deficit, leading to government borrowing

Question 4

What is contractionary fiscal policy and what effect will it have on the budget?

Answer 4

Decreasing AD

• cut government spending
• hike taxes -> reducing consumption
• improves the budget deficit

Question 5

What is meant by crowding out?

Answer 5

When the government increases spending it must increase borrowing.

• This borrowing comes from private sector
• When the private sector loan out money to the government, they will have less money for consumption and investment.
• This will decrease AD and have a reverse effect on the expansionary fiscal policy

Question 6

What are other limitations of fiscal policy aside from crowding out?

Answer 6

1. Time lags
   - Increasing government spending takes time. Could take months for a government decision to filter through the economy and effect AD
2. Poor information
   - the government may struggle to put in place effective policy as they have limited information about the state of the economy
3. Government spending is inefficient
   - free market economist argue that higher govt spending will be wasted on inefficient spending projects.
   - This then may lead to governments being pressured into continuing such inefficient projects due to political pressures and so can’t easily reduce spending again.

Question 7

What does the success of fiscal policy depend upon?

EVALUATION

Answer 7

The size of the multiplier
- if the multiplier is large then changes in govt spending will have a bigger effect on AD

The state of the economy

• Fiscal policy is most effective during a deep recession when monetary policy is insufficient
• In a deep recession (liquidity trap), higher government spending will not cause crowding out as private sector savings have increased substantially.