Fiscal Policy

Question 1

Define fiscal policy

Answer 1

Government policy that utilises government spending and tax revenue to influence AD

Question 2

Define budget deficit

Answer 2

Government spending>tax revenue

Question 3

Define budget surplus

Answer 3

Government spending

Question 4

Define automatic stabilisers

Answer 4

Changes to government expenditure that happen automatically due to the economic cycle and do not require a change in government policy

Question 5

Explain how during a recession automatic stabilisers impact AD

Answer 5

During a recession AD falls as there is little tax revenue and benefits increases. Government spending increases to these benefits so consumption and government spending both increases which reduces the impact of the recession.

The government spending money is expansionary fiscal policy

Question 6

Explain how automatic stabilisers work during a economic boom

Answer 6

AD is very high therefore government has a high tax revenue because more taxes are collected than benefits are given in. This a situation of a budget surplus as government spending is low. This results in AD falling.

This is contractionary fiscal policy

Question 7

Define average rate of taxation

Answer 7

100x(total amount of tax paid/total income)

Question 8

Define marginal rate of taxation

Answer 8

100x(🔺change in amount of tax paid/🔺change in total income )

Question 9

What does the laffer curve show and what is its shape?

Answer 9

The relationship between government tax revenue and tax rate. It is an inverted parabola.

Question 10

Explain the shape of the Laffer curve

Answer 10

Between a tax rate of 0% to x% people are prepared to pay a high tax rate therefore the increasing tax rate increases government tax revenue.

However a tax rate >x% would lead to tax evasion and brain drain which decreases tax revenue.

Question 11

Advantages and disadvantages of a small state

Answer 11

Advantages:
-Low tax rates
-Increases incentive to work & fulfil enterprise and innovation 
 Disadvantages:
-Income inequality 
-Presence of market failure 
-No provision of public goods

Question 12

Advantages and disadvantages of a large state

Answer 12

Advantages:

• Reduced income inequality
• Reduced social unrest
• Intervention in markets that are failing

Disadvantages:

• Poor consumer choice
• Low levels of innovation due to high tax rates
• No incentive to work (replacement ratio)

Question 13

What happens if the government attempts to run expansionary fiscal policy during a budget deficit and what curve can demonstrate this?

What is the effect of this on private investment?

Answer 13

Government have to borrow money from domestic banks through selling bonds. Demand increases and interest rates increases. Use interest rate diagram with inelastic supply of money.

Domestic investment falls as the cost of borrowing has increased.

Question 14

What is “crowding out”?

Answer 14

When increased government demand for loanable funds (e.g: bonds) increases and causes the domestic IR and reduces investment by making it less profitable (lower returns on investment)

Question 15

How can the concept of “crowding out” be used as evaluation?

Answer 15

Expansionary fiscal policy is far less than we had imagined because AD does not increase as much as we analysed because of the fall in investment

Question 16

Define “crowding in”

Answer 16

A decrease in government demand for loanable funds decreases the domestic IR and increases investment by making it more profitable

Question 17

What happens if the government try to run contractionary fiscal policy through a budget surplus and what is the effect on investment?

Answer 17

In order to enact contractionary monetary policy, the government has to cut spending and increase taxes. However, when reducing spending the governments demand for loanable funds fall and so the interest rate falls. This increases profitability of investments as the cost of borrowing has fallen and so AD does not fall as much as we first analysed.