fiscal policy Flashcards
which two levers are manipulated by fiscal policy
government spending and taxes. by adjusting G & T, government can influence AD. higher spending and/or lower taxes boosts AD, while the opposite contracts it,
government expenditure
capital expenditures, current expenditures, transfer payments
capital expenditure (government expenditure)
these are investments in infrastructure, such as roads, bridges and schools. capital expenditures are important for long-term economic growth.
current expenditure (government expenditure)
these are day-to-day expenses, such as salaries for government employees and payments for social programs. current expenditures are important for providing essential services to citizens.
transfer payments (government expenditure)
these are payments made to individuals or businesses, such as social security benefits or unemployment benefits. transfer payments are not counted as part of GDP because they do not represent the production of goods or services.
sources of government revenue
taxes, fees and charges & sale of assets
taxes (government revenue source)
taxes are the main source of government revenue. there are two main taxes: direct taxes which are levied on individuals and businesses, and indirect taxes, which are levied on goods and services.
fees and charges (government revenue source)
governments also collect fees and charges for services they provide, such as driver’s licenses and park permits
sale of assets (government revenue source)
governments may sell assets, such as land or buildings, to generate revenue
budget deficit
if government expenditures exceed tax revenues in any given year
budget surplus
if tax revenues exceed government expenditures in any given year
balanced budget
if government expenditures are equal to tax revenues
financing a budget deficit
borrowing money from public or from financial institutions. when government borrows money, it issues bonds. bonds are essentially loans that the government makes to the public. the government pays interest on the bonds it issues to the public.
short term goals of discretionary fiscal policy
lift an economy out of recession, decrease cyclical unemployment, control inflation, decrease trade imbalances
discretionary fiscal policy to lift an economy out of recession
by increasing government spending and reducing taxes, expansionary fiscal policy stimulates AD, increase real GDP and creates jobs, pulling the economy out of a downturn.
discretionary fiscal policy to decrease cyclical unemployment
as the economy grows due to expansionary fiscal policy, more jobs are created and cyclical unemployment falls
discretionary fiscal policy to control inflation
fiscal policy can play a role in managing inflation, although contractionary monetary policy is usually the primary tool. contractionary fiscal policy by reducing G and/or raising T can help fight inflation
discretionary fiscal policy to decrease trade imbalances
fiscal policy can be used to adjust G and T to influence imports and exports, potentially helping to manage trade imbalances
long term impact of fiscal policy
promote faster growth, improve infrastructure, reduce income inequality
fiscal policy to promote faster growth
prudent fiscal policy, with moderate deficits and controlled debt, fosters a stable economic environment that encourages business investment and long-term growth
fiscal policy to improve infrastructure
public investments in infrastructure can boost short-term growth through increased demand and long-term growth by enhancing productive capacity
fiscal policy to reduce income inequality
progressive taxation and targeted cash transfers can redistribute income and address inequality in the short-run resulting in increasing equity (fairness) in access to education and healthcare can provide long-term growth
goals of expansionary fiscal policy
stimulate AD and lift the economy out of recession or deflation
tools and impact of expansionary fiscal policy
increase government spending –> directly boosts AD as G is a component
decrease taxes –> raises disposable income of households and after tax profits of firms, leading to increased consumption spending due to higher disposable income & increased investment spending due to higher after tax profit incentivising firms to invest more.
the increase in real GDP generated by expansionary policy can be greater than the initial increase in G or T cuts due to the multiplier effect.
as government injects more money into the economy via increased government spending, businesses and individuals spend more, creating income for others.
this new income leads to further spending, multiplying the initial impact of the policy.
goals of contractionary fiscal policy
reduce AD combat inflation and close an inflationary gap
tools and impact of contractionary fiscal policy
decrease government spending –> directly reduces AD as G is a component
increase taxes –> lowers disposable income of households and after-tax profit of firms, leading to decreased consumption spending & decreased investment spending
AD curve shifts left, reducing real GDP and potentially reduced inflation
severe contraction could lead to deflation but this is rare
Keynesian multiplier
pebble analogy:
initial splash (increased government spending) creates ripples (increased income and spending), amplifying the impact (multiplier effect) –> additional income and spending creates further ripples, repeating the cycle and boosting overall economic activity (real GDP) –> happens because each round of spending generates additional income which is then spent again, creating a chain reaction
factors affecting size of multipliers
marginal propensity to consume (MPC) : the percentage of additional income people spend
leakages: savings, taxes, and imports that reduce the impact of spending (MPS, MPT, MPM)
benefits of the Keynesian multiplier
can stimulate sluggish economy and reduce unemployment, can help combat deflationary pressures
drawbacks of the Keynesian multiplier
can increase government debt if not implemented carefully, can lead to inflation if not paired with responsible monetary policy
automatic stabiliser
built in features of fiscal policy that react automatically to economic fluctuations, mitigating their impact
automatic stabilisers during recessions
unemployment benefits: as unemployment rises, automatic payments cushion the income loss of laid-off workers, boosting their spending and preventing a deeper downturn.
progressive taxation: as incomes fall, tax burdens automatically decrease, leaving more money in people’s pockets to spend, again supporting aggregate demand.
automatic stabilisers during booms
unemployment benefits: as unemployment reduces, automatic payments reduces, preventing excess spending and AD
progressive taxation: as incomes rise, tax burdens automatically increase, siphoning off excess spending and AD thus preventing inflation form spiralling out of control
benefits of automatic stabilisers
stability, efficiency, equity
stability due to automatic stabilisers
automatic stabilisers act as a safety net, cushioning the impact of economic ups and downs without requiring immediate policy intervention (built-in)
efficiency due to automatic stabilisers
they operate automatically, without the need for complex political negotiations, making them a quicker and more efficient response to economic changes
equity due to automatic stabilisers
progressive taxation and unemployment benefits can help to reduce income inequality during both recessions and booms
limitations of automatic stabilisers
limited effectiveness, effect/action lags, cost
limited effectiveness of automatic stabilisers
they may not be sufficient to completely prevent deep recessions or severe inflation, hence the need for discretionary fiscal policy
effect/action lags of automatic stabilisers
their effects may take time to materialise, meaning they may not be able to react instantaneously to economic changes
cost of automatic stabilisers
maintaining automatic stabilisers requires ongoing government spending, which can contribute to fiscal imbalances in the long run
crowding-out effect
occurs when increased government spending leads to higher interest rates, which can discourage private investment.
government borrows to finance increased G, entering the loanable funds market.
higher demand for funds raises interest rates, making borrowing more expensive for firms.
firms may reduce investment due to higher borrowing costs, negating some of the intended demand boost from G.
criticisms of the crowding-out effect
monetarists argue crowding-out limits the effectiveness of fiscal policy in stimulating aggregate demand.
however, crowding-out is less likely in deep recessions where private investment is already weak.
effectiveness of fiscal policy (advantages)
direct impact, multiplier effect, targeted spending, tax cuts for the poor, long-term benefits, scalability, automatic stabilisers
direct impact of fiscal policy
increased government spending directly boosts AD, especially important in deep recessions when other policies are in effective (commonly used to complement MP when it is showing stubborn effect/action lags)
multiplier effect of fiscal policy
increase in spending triggers a chain reaction of spending and income growth, amplifying the initial impact to close any deflationary gap or recession
targeted spending of fiscal policy
can be directed to specific sectors or regions to address specific needs, inequalities & inequities while stimulating AD & real GDP
