Fiscal policy

Question 1

Which of the following fiscal policy options is the UK government likely to pursue in order to get the economy out of a recession?

Answer 1

In a recession, the government will want to use fiscal policy to increase aggregate demand. They will therefore choose to decrease taxes in order to encourage consumption. They will also spend more money. By decreasing tax and increasing spending they will need to borrow more money, which will worsen the budget deficit.

Question 2

Fiscal Policy

Answer 2

The government changing tax and government spending to influence the economy.

Question 3

Contractionary Fiscal Policy

Answer 3

The government increasing tax and decreasing government spending in order to reduce aggregate demand.

Question 4

Expansionary Fiscal Policy

Answer 4

The government decreasing tax and increasing government spending in order to increase aggregate demand.

Question 5

Who’s in charge of the inflation rate in the UK

Answer 5

Bank of England

Question 6

The Institute for Fiscal Studies estimates that, since 2010, there has been a real terms cut in the budget for the Ministry for Justice of 40%. There have been cuts in many other departments as well, such as a 17% real terms cut for the Department for Education.

Which of the following is this an example of?

Answer 6

Contractionary fiscal policy occurs when the government increases tax and decreases government spending in order to expand the economy. The extract describes cuts to government spending, so this is contractionary fiscal policy.

Question 7

What effect would Investing in infrastructure have

Answer 7

would be a supply-side policy and would help to increase the long run potential of the economy. It allows businesses to operate more efficiently and increase productivity. This would shift LRAS to the right as shown.

Question 8

Explain the multiplier effect on the economy following a reduction in the income tax rate.

Answer 8

A lower income tax rate means that workers have a higher disposable income and therefore consume more. The increase in consumption increases aggregate demand. As consumers spend more, firms will make more sales and therefore more profit. This means that they can invest more. Because investment is a positive component of aggregate demand, AD will increase further.

As consumers spend more and firms make more profit, corporation tax and VAT revenues will increase. This means that the government can spend more and so AD will increase further. As firms expand, they will increase their derived demand for labour, so incomes will increase. This will further increase spending and income tax revenue, causing consumption and government spending to increase further. So, the overall impact on aggregate demand will be much larger.

Question 9

What is the most likely impact of a reduction in government spending?

Answer 9

Government spending is a component of aggregate demand. So, a reduction in government spending will reduce AD.

Question 10

Explain the downward multiplier effect following an increase in the income tax rate.

Answer 10

A higher income tax rate means workers have a lower disposable income and therefore consume less. The decrease in consumption decreases aggregate demand. As consumers spend less, firms will make fewer sales and therefore less profit. This means that they can invest less and so AD will decrease further as investment is a positive component of AD.

As consumers spend less and firms make less profit, corporation tax and VAT revenues will decrease. This means the government can spend less and so AD will decrease further. As firms contract, they will decrease their derived demand for labour and so incomes will decrease. This will further decrease spending and income tax revenue and so consumption and government spending will further decrease. So, the overall impact on aggregate demand will be much larger.

Question 11

What effect does the income tax rate have on inflation?

Answer 11

Raising the income tax rate for high earners decreases their disposable income. This will decrease consumption and aggregate demand, which will help to bring the price level down and control inflation. Also, a higher income tax rate will increase income tax revenue and help the government to balance its budget.

Question 12

What are benefits?

Answer 12

Benefits are payments or transfers made by the government to unemployed or low income or low-income workers.

Question 13

the benefits trap.

Answer 13

When benefits get too high and unemployed workers are actually better

off staying unemployed and claiming benefits than working.

Question 14

disadvantage to increasing corporation tax

Answer 14

However, increasing corporation tax means that firms make less profit and are likely to reduce their investment in capital, which causes depreciation. This makes them less productive and reduces LRAS.

Question 15

Which of the following is the most likely impact of a reduction in the corporation tax rate?

Answer 15

A right shift of SRAS occurs if costs decrease. A reduction in corporation tax rate will decrease costs.

Question 16

one advantage of decreasing corporation tax.

Answer 16

One advantage of decreasing corporation tax is that it should lower costs for firms. This will shift SRAS to the right and increase real GDP in the short run. Also, firms can keep more of their profit, so they are likely to increase investment, which will increase AD. Increasing investment will increase the productivity of capital and shift LRAS to the right, leading to economic growth.

Question 17

one disadvantage of decreasing corporation tax.

Answer 17

However, decreasing corporation tax means that the government will receive less tax revenue. Also, the extra profit from reducing corporation tax might just be kept by the owners instead of being used for investment.

Question 18

one advantage to government spending more on healthcare and education.

Answer 18

An increase on government spending is an increase in G, which increases aggregate demand and, therefore, real GDP. Specifically, spending on healthcare and education will make the workforce healthier and more productive, so the LRAS will shift right.

Question 19

one disadvantage to the government spending more on healthcare and education.

Answer 19

However, this spending will worsen the government’s budget deficit. Furthermore, spending on schools and education could go towards unproductive bureaucracy or useless degrees.

Question 20

Which of the following is likely to occur as a result of the reduction in wages?

Answer 20

A reduction in wages will reduce costs, which will shift SRAS to the right.

Question 21

one disadvantage to the government spending less on healthcare and education.

Answer 21

A reduction in spending on education means a higher labour supply which can lower wages and therefore lower real costs for firms. This will shift SRAS to the right and increase real GDP.

Question 22

one advantage to the government spending less on healthcare and education.

Answer 22

However, a reduction in spending on healthcare and education means that the workforce is less productive, so LRAS will shift left, reducing real GDP.

Question 23

Which of the following is likely to occur after a firm’s costs increase due to an increase in VAT?

Answer 23

An increase in costs will shift SRAS inwards (to the left)

Question 24

one disadvantage to the government increasing VAT.

Answer 24

an increase in VAT will increase costs for firms, which will shift SRAS inwards. This can reduce economic growth and leads to cost push inflation.

Question 25

Explain one advantage and one disadvantage to the government decreasing VAT.

Answer 25

A decrease in VAT will decrease costs for firms, which will increase SRAS. This will increase real GDP and economic growth, and also bring the price level down.

However, a decrease in VAT will also decrease tax revenue and worsen the budget deficit.

Question 26

What would cause a right shift in LRAS and SRAS

Answer 26

A decrease in corporation tax will decrease the costs of production. This will shift SRAS to the right. It also means that firms are able to keep more of their profits, which they can invest in capital. This investment will increase the productivity of capital and shift LRAS to the right.

Question 27

Which of the following shows the likely impact of an increase in Value Added Tax (VAT)

Answer 27

Inflation, caused by a decrease in short run aggregate supply

Question 28

Which of the following shows a likely impact for a private firm of the government borrowing to spend on land, labour and capital?

Answer 28

Government borrowing has pushed up the interest rate and the price of land, labour and capital. This means prices for firms are higher and so their costs will increase. An increase in costs will reduce supply and shift the firm’s supply curve to the left.

Question 29

Which of the following shows a likely impact for the economy of the government borrowing to spend on land, labour and capital?

Answer 29

Government borrowing has pushed up the interest rate and the price of land, labour and capital. This means that prices for firms are higher, and so their costs will increase. An increase in costs will reduce supply and shift the firm’s supply curve to the left. This occurs for all the firms in the economy, so SRAS will shift left.

Question 30

Which of the following is most likely to occur as the government increases its demand for borrowed money, land, labour and capital?

Answer 30

Increased interest rate

Increased demand for money will push up the ‘price’ of money - the interest rate.

Question 31

Infrastructure

Answer 31

Items needed for businesses to operate such as roads and telecommunications networks.

Question 32

Crowding Out

Answer 32

When government spending increases, the government demands more borrowed money, land, labour and capital. The price and interest rate increases which increases costs for firms and reduces supply.

Question 33

When inflation is below the target, the Bank of England is likely to…

Answer 33

If inflation is below its target, the Bank of England will want to increase AD in order to bring the price level up. To increase AD, they will need to reduce the interest rate. This will encourage consumers to save less and consume more. It will also encourage firms to invest as it is cheaper to borrow. Both of these will increase AD and inflation.

Question 34

Which of the following policies is likely to be adopted by the Bank of England if the inflation rate is below its target?

Answer 34

If the inflation rate is below target the MPC will want to expand the economy and increase AD in order to increase the inflation rate. This means pursuing expansionary monetary policy by decreasing the interest rate. A lower interest rate encourages consumers to spend rather than save and it encourages firms to borrow to invest. This will increase AD and inflation.

Question 35

What are the Bank of England likely to do if the inflation rate in the UK reaches 1%?

Answer 35

Reduce the interest rate through expansionary monetary policy

Question 36

Which of the following is a definition for the base interest rate?

Answer 36

The rate at which the central bank will lend to highstreet banks

Question 37

The diagram below shows the aggregate supply and demand curves for the UK economy. The AD curve shifts from AD to AD1 as shown on a LRAS diagram
What are the Bank of England likely to do in this situation?

Answer 37

The inflation target in the UK is 2% +/- 1%. The graph shows that the economy is operating at the full employment level of output. The increase in AD has led to demand pull inflation. The Bank of England will want to reduce this inflation rate so that it is back within the target range. They reduce the inflation rate by reducing AD and contracting the economy. They reduce AD by increasing the base interest rate in order to encourage saving and discourage borrowing.