Fiscal Policy

Question 1

What is fiscal policy?

Answer 1

Fiscal policy is changes in government spending and taxation in order to infuence AD.

Question 2

Why might the government want to use expansionary fiscal policy?

Answer 2

-Boost growth
-Reduce unemployment
-Increase inflation
-Redistribute income

Question 3

Why might the government want to use contractionary Fiscal policy?

Answer 3

-Reduce inflation
-Reduce budget deficit/national debt
-Redistribute income
-Reduce current account deficit

Question 4

Standard EV - Conflict with other macroeconomic objectives

Answer 4

• However, perhaps the government engaging in expansionary fiscal policy may not be desirable, due to a clash in macroeconomic objectives.
• If there is a rise in government spending in the economy. For example, the government spending on infrastucture projects to tackle issues surrounding the geographical immobility of labour. Then aggregate demand will rise in the economy, as government spending, a component of aggregate demand rises which in turn increases aggregate demand (ceteris paribus)
• Consequently, there is a rightwards shift in AD from AD1-AD2, which boosts real national output and incomes from Y1-Y2.
• Furthermore, with the investment of infrastucture projects, there are more jobs created in the economy. As a result, more people will have incomes and higher incomes, which ceteris paribus, means that consumers have higher disposable incomes.
• As a result, consumption of normal luxury goods will rise in the economy (ceteris paribus), thus inducing a multiplier effect shifting AD again from AD2-AD3, boosting real national output and incomes further (Y1-Y3).
• Due to the government utilising expansionary fiscal policy, economic growth a macroeconomic objective takes place.
• However, due to the government implementing expansionary fiscal policy, prices in the economy will rise, ceteris paribus, from pl1-pl3. Consequently, this will increase inflation perhaps above the 2% target going against a macroeconomic objective.
• Therefore expansionary fiscal policy may not be as desirable as it depends upon government macroeconomic objectives and priorities.

Question 5

Def+the point AD1+thepointAD3

Standard EV - Depends upon the size of the output gap

Answer 5

(draw a keynsian LRAS diagram with 4 aggregate demand curves, one with lower spare capacity, one with higher spare capacity)
* However, perhaps expansionary fiscal policy may not be desirable as it depends upon the size of the output gap.
* The output gap is the difference between the actual output of the economy versus the potential output when at full capacity.
* If the government undergoes expansionary fiscal policy at the point AD1 and Y1 i.e when there is a large negative output gap aggregate demand shifts from AD1-AD2, thus boosting real national output and incomes (Y1-Y2) and the economy benefits from all the positives of economic growth.
* However, if the government undergoes expnasionary fiscal policy at the point AD3 and Y3 i.e when there is a very small egative output gap AD shifts from AD3-AD4, the benefits of economic growth is minimal and the policy is going to be inflationary i.e increase demand-pull inflation.
* Consequently, living standards may fall (other examples too and why)…

Question 6

If gov borrows to promote growth+example+sell bonds bought by consumers

Standard EV - Crowding Out

demand for loanable funds+shift+extension+crowdingout

Answer 6

(this is evaluation for expansionary fiscal policy - use supply and demand diagram - price = interest rate and quantity)
* However, perhaps expansionary fiscal policy is not desirable in the long-run as this can harm long-run economic growth due to the crowding out effect.
* If the government wants to spend more money in order to stimulate economic growth but has to borrow money to do so, the crowding out effect can occur.
* For example, the government may want to spend money on an infastucture project to boost economic growth. However, they may need to borrow money to so.
* As a result, they will sell government bonds in order to fund the project which are bought by consumers, firms etc. (loanable funds)
* Consequently, when the government decides to spend money while borrowing the demand in the market for loanable funds increases, resulting in a rightwards shift in demand in the market for loanable funds from D1-D2 and an extension of supply from Q1-Q2.
* However, there is an upwards pressure on market interest rates, causing them to increase from i1-i2.
* This can then cause the “crowding out” effect in the private sector as since interest rates are higher investment in capital goods is witheld due to higher interest rates.
* Consequently, this can decrease economic growth in the short-run as investment is a component of aggregate demand (ceteris paribis) and economic growth in the long-run as the stock of capital goods by firms in the economy will not rise in the economy thus not boosting LRAS (ceteris paribus)
* Therefore, government spending driven by borrowing may not be desirable to carry out expansionary fiscal policy.
* However, this is unlikely to occur in a recession due to low business confidence and a lot of spare capacity mitigating the need for greater investment.

Question 7

Evaluation - Ricardian Equivalence

Answer 7

• However, perhaps expansionary fiscal policy is not desirable as it can cause Ricardian equivalence to occur.
• If the government funds its spending on x through borrowing through the use of government bonds, ultimately the government will have to pay back those bonds through taxation i.e in the long-run the government needs to balance its budget.
• As a result, consumers are “forward-thinking” and anticipate rises in taxation in the future, leading to an increase in the average propensity to save in the economy (ceteris paribus) as consumers want to maintain their standard of living in the future if there is a rise in taxation.
• Consequently, consumption will decrease in the future which, ceteris paribus, decreases aggregate demand……

Question 7

What are the points you would make for reducing a budget deficit?

Answer 7

• Increased taxes
• Reduced government spending
• Economic growth

Question 8

What are 3 points in favour of running a budget surplus/not running budget deficits?

Answer 8

• Reduce the effects of crowding out
• Reduced inflationary pressure on the economy
• potentially reducing the debt burden –> if the government have a high bugdet deficit, this may lead to a fall in confidence for the governments fiscal plans –> this may require higher rates of interest to borrow (out of fear of defaulting on debt) or higher coupons on government bonds –> increases debt again for the government. Furthermore, this may be exasberated by lower credit ratings for the government e.g in 2013 in the UK lenders will charge greater interest due to higher percieved risk.

Question 8

What are 3 points in favour of not running a budget surplus/running budget deficits?

Answer 8

• increased economic growth –> higher tax revenues in the future
• May be crowding in effects where higher government spending promotes greater private sector investment as incomes and ecomomic growth rise.