fiscal policy : an introduction Flashcards
what does fiscal policy involve ?
Fiscal Policy involves the use of government spending and taxation (revenue) to influence aggregate demand in the economy
It can be expantionary or contractionary
what does fiscal expansionary policy mean?
iscal policy can be expansionary in order to generate further economic growth
Expansionary policies include reducing taxes or increasing government spending
what does fiscal contractionary policy mean ?
Fiscal policy can be contractionary in order to slow down economic growth or reduce inflation
Contractionary policies include increasing taxes or decreasing government spending
what are the macro economic impacts of fiscal policy
he use of fiscal policy aims to
Maintain a low and stable rate of inflation
Maintain low unemployment
Reduce the business cycle fluctuations
Create a stable economic environment for long-term economic growth
Redistribute income so as to ensure more equity
Control the level of exports and imports (net external balance)
When a policy decision is made, it creates a ripple effect through the economy, impacting the macroeconomic objectives of the government
Changes to fiscal policy can influence several of the components of AD
A change to any component of AD helps to achieve at least one of the goals of fiscal policy
what are the microeconomic impacts of fiscal policy ?
Fiscal policy includes making changes to policies such as taxes and subsidies
Income tax cuts can influence labour to be more productive
Tax cuts can encourage firms to increase output or be more entrepreneurial
Subsidies can lower costs of production in the industry, leading to higher output
what does expansionary fiscal policy include?
Expansionary fiscal policies include reducing taxes or increasing government spending with the aim of increasing AD
AD = household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
AD = C + I + G + (X - M
Expansionary fiscal policy aims to shift aggregate demand (AD) to the right
draw a diagram of expansionary fiscal policy
diagram analysis
Diagram analysis
The economy is initially in macroeconomic equilibrium AP1Y1: there is a recessionary gap
The Government wants to boost economic growth and lowers the rate of income and corporation taxes
Lower taxes cause investment and consumption to increase, which are components of AD
Aggregate demand increases from AD→ AD1
The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a greater level of national output
what does contractionary fiscal policies include ?
Contractionary fiscal policies include increasing taxes or decreasing government spending with the aim of decreasing AD
AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
AD = C + I + G + (X - M
Changes to fiscal policy can influence government spending or consumption or investment
Changing taxation can influence household consumption and the investment by firms
Contractionary fiscal policies aims to shift aggregate demand (AD) to the left
diagram for contractionary fiscal policy
diagram analysis
The economy is initially in macroeconomic equilibrium AP1YFE - an inflationary output gap is developing
The economy is booming and the Government wants to lower inflation towards its target of 2%
The Government increases the rate of income tax
Higher tax rates cause households to have less discretionary income, causing consumption to decrease
Aggregate demand decreases from AD1→ AD2
The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller level of national output
Examples of the Impact of Contractionary Fiscal Policy - The Government increases the rate of income tax
Effect on the economy - Households pay more tax → discretionary income reduces → consumption reduces → AD reduces
Impact on macroeconomic aims -
Economic growth slows down
Inflation eases
Unemployment may increase as output is falling and fewer workers are required
Net external demand Improves (with less income, imports may fall)
Examples of the Impact of Contractionary Fiscal Policy - The Government freezes/reduces public sector workers pay
Effect on the economy-Wages stagnate or reduce → Consumer confidence falls → consumption decreases → AD decreases
Impact on macroeconomics aims -
Economic growth slows down
Inflation eases
Unemployment may increase as output is falling
Net external demand improves (with less income, imports may fall)
Examples of the Impact of Contractionary Fiscal Policy - The Government cuts Government Spending in their Budget
Effect on the economy -Less demand for goods/services → less income for firms → output and profits decrease → AD decreases
Impact on macroeconomic aims -
Economic growth slows down
Inflation eases
Unemployment may increase as output falls
Net external demand may Improve (with less income, imports may fall)
Less corporation tax available for redistribution
effects in a recession
In a recession, there will automatically be lower tax revenue due to the nature of progressive taxation - as incomes fall households are taxed less
In a recession, as unemployment rises, the government will pay higher unemployment benefits and transfer payments, which households will then use for consumption
Both of the above will result in real GDP being higher than it would otherwise have been
effects in a boom
n a boom, there will automatically be higher tax revenue due to the nature of progressive taxation - as incomes rise, households are taxed more
In a boom, as unemployment falls, the government will pay fewer unemployment benefits / transfer payments which will decrease household consumption
Both of the above will result in real GDP being lower than it would otherwise have been
This is effectively an automatic disinflationary effec
