Fiscal Policy Flashcards
What is fiscal policy
Refers to the use of government spending and taxation to regulate economic output and achieve macroeconomic objectives.
Government spending and taxation.
Governments can change amount of spending and taxation to stimulate the economy. Fiscal policy aims to stimulate the economy. The more ta revenues a government has the more money it has to fund public services
Aggregate demand
Total demand for goods and services in an economy.
Higher AD - more robust economy.
Lower AD - economy is experiencing a recession or downturn.
Expansionary fiscal policy
Aims to increase aggregate demand in an economy experiencing a recession An increase in gov spending which is a component of AD shifts AD curve right.
Governments increase spending and reduce taxation. Through higher household disposable income leading to higher spending. Shifts AD curve right.
Can lead to worsening of the governments budget deficit and may mean gov have to borrow more.
Expansionary fiscal policy diagram explanation
Initial equilibrium of national income is where AD1 & SRAS1 intersect
Output is Y1 and price level is P1.
When gov decides to cut taxes or increase gov spending the AD curve shifts rightward from AD1 to AD2 and economy reaches a new equilibrium of Y2
Further expansionary fiscal policy
The government may use tax stimulus to fuel economic growth and inc AD.
When people pay lower taxes, have more money to spend or invest, fuels higher demand
- Leads to a decrease in unemployment. This raises wages and provides consumers with more income to spend and invest. - positive feedback loop
Gov can seek economic expansion by increasing spending by building more highways which could increase employment, pushing up demand and growth .
Budget deficit
Deficit spending occurs when government expenditure exceeds receipts from taxation.
Contractionary fiscal policy
Uses higher taxes and lower government spending to regulate the economy.
Lowers aggregate demand by raising taxation and reducing gov spending, which reduces consumer spending and leads to an improvement in budget deficit.
A tax increase has indirect effect on AD, lower disposable income so lower spending shifting AD curve left
Diagram explanation of contractionary fiscal policy
Initial national income equilibrium is at intersection of AD curve and AS curve of AD1 and SRAS1. Output is Y1 and price level is P1.
When government decides to raise taxes or cut spending AD curve shifts inwards from AD1 to AD2.
As a result economy moves to a new equilibrium output of Y2 with price level of P2
Demand side fiscal policy
Is adopted in times of recession to stimulate economic growth
By increasing gov spending and lowering taxes gov can encourage people to spend more.
As a result demand for goods and services and level of consumption increases
Companies can then generate more revenue which allows them to increase production and hire more employees
Supply side fiscal policies
Uses privatisation, deregulation, tax cuts and free trade agreements to increase AS and economic efficiency.
E.g a cut income tax which will motivate workers to work longer as they will earn with lower taxes
As a result the level of productivity and output will rise
Non interventionist supply side policies
Tax cuts - to create an incentive to work save and invest
Welfare benefits cuts - to lower incentive to seek unemployment
Privatisation - shifts ownership of publicly owned assets to private sector
Intervnetionist supply side policies
Government provision for private sector firms
Government provisions or training education and infrastructure
Gov can subsidise training or spend more on education which lowers costs for firms as they have to train less workers.
Spending more on healthcare helps improve the quality of labour force and contributes towards higher productivity
Supply side policies
Aim to improve the long run productive potential of the economy
Aims of supply side policies
Increase incentives - gov could reduce income and corporation tax to encourage spending and investment
To promote competition - by deregulating and privatising firms can compete in a competitive market which should help improve economic efficiency
To I,prove skills and quality of labour force by subsiding training or spending more on education which lowers costs for firms as they have to train fewer workers
Evaluation of supply side policies
Positive - only policies that can deal with structural unemployment as labour market can be directly improved with education and training
Negative - demand side can reduce negative output gap and deal with cyclical unemployment and shifts AD curve to right
- time lags
- market based SSP such as tax could lead to more unequal distribution of wealth
Supply side policies diagram explanation
In short run tax cut ;
- motivates workers to work long hours contributing to higher productivity and output.
- SRAS shifts from SRAS1 to 2 rightward.
In long run tax cut -
Causes LRAS to shift right from LRAS1 to 2.
Level of productive capacity rises from Y1 to Y2
And price level falls from P1 to P2
Government budget
Budget deficit : when expenditure exceeds tax receipts in a financial year
Surplus : when tax receipts exceed expenditure
National debt : total accumulation of government deficit over time
Consequences of budget deficit and surpluses
Fiscal deficit could be inflationary if it increases AD
- more gov spending can lead to crowding out of the private sector. This leaves fewer funds in the private sector for firms to use since the government is borrowing money which crowds them out of the market
- could leave to inc interest rates because the gov has to offer injectors an attractive rate in order to encourage to buy debt
Significance in size of national debt
Cost of borrowing could increase as by borrowing money gov is increasing demand for credit
- if confidence is lost in gov ability to repay debt governments might have to raise interest rates to encourage investors to buy bonds so they can finance the debt
- can lead to higher taxes and austerity measures if debt becomes uncontrollable.
Evaluation of fiscal policy
- Depends on how gov spending is financed. If gov spending is financed by higher taxes then tax rises may counter bananas the higher spending therefore there will be no increase in AD
- Crowding out - if economy is close to full capacity then higher gov spending can lead to crowding out. This is when government spends more but has effect of reducing private sector spending.
- Depends on state of economy if economy is close to full capacity then higher gov spending may cause inflationary pressures and little increase in as.
Cons
- Higher demand pull inflation - worsening of government finances. -Income + corporation tax can widen inequality crowding out
When gou spending is borrowing fuelled s reduces private sector investment incaemand for loadable funds. Less investment so prate sectors crowded out.
Timelags → infrastructure
→ tax cuts take time to feed through to economy.
Evaluation
→ size of output gap A close to full capacity. Demand pull inflation
→ depends on size of multiplier.it multiplier smaller need for largegouspending so impact on government debt may not bethat large
→ consumer+ businessconsidence → may not use to save or invest
→ snort runt long run effects on government
Snow run higher debt but in long run, the returns outweighs
Laffer curve → income tax cut leads high tax revenues for governments. Incentives that income tax cut generates. Incentive to work harder, longer hours and more productive to earn more income to keep more income to keep as disposable income
Crowding out effect - Keynesian’s economists would disagree with crowding out. Risk of crowding out is low in a recession e
Laffer curve
Infers that a tax rate cut could lead to an increase in tax revenue or decrease.
