Fiscal policy (Topic 12) Flashcards
G vs C & I
Private sectors (C & I) make their decisions based on personal interest
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Their combined decisions may be insufficient (which may lead to unemployment) or excessive (which may lead to inflation)
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C & I cannot be counted upon to spend more when AD is too low or spend less when AD is too high
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Therefore, the government is needed to step in to stabilise the economy at or near full employment
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By using fiscal policy (use of the government’s budget) or monetary policy (change in money supply)
Sources of government revenue
1) Main source is derived from taxes
[Direct taxes (income and property tax) and indirect taxes (GST)]
2) Non-tax revenue
[Investment income, income from sales of goods & services, repayment of government loans]
Government budget
T > G (budget surplus)
T < G (budget deficit)
T = G (balanced budget)
Expansionary fiscal policy, what is lump sum tax
Budget deficit
Rising G or lower taxes
Use when the economy is in a recession
Decreases T → Increase Yd (MUST talk about disposable income) → Increase C → Increase AD → AD shift to right → Increase Y by multiple
Disposable income is the income that ultimately gets to households
Lump sum tax is tax of a constant amount that is paid regardless of the income level
Contractionary Fiscal Policy
Budget surplus
Lowering G or increasing taxes
Use when the economy is in an inflationary situation
Increase T → decrease Yd (MUST talk about disposable income) → decrease C → decrease AD → AD shift to the left → Decrease Y by a multiple
Tax multiplier equation
∆ = -MPC / MPS x ∆T
Drawbacks of using FP
1) Timing problem
Recognition lag
occurs because time is needed to identify the stage of the business cycle a country is at before deciding on the appropriate policy to adopt
Administrative lag
time needed to obtain approval from various parties to change taxes or government spending
Operational lag
Fiscal policy enacted now requires time via the multiplier to work through the economy and affect income. By then, there may be a change in economic conditions so that the opposite fiscal policy is required
2) Political consideration
The adoption of expansionary FP, comprising and increase in G or decrease in T, tends to make the government more popular
Tendency for FP to be expansionary despite the fact that it may not be the right policy to adopt
3) Crowding-out effect
Reduces the impact of the FP
When the government decides to increase government spending to help simulate the economy by borrowing, the demand for funds in the country will increase.
Increase in G → AD to the right
But Increase in demand for funds → increase in interest rates → C & I fall → AD to the left
4) Inflation
Expansionary FP → increase AD and Y by a multiple but may lead to inflation
People cut back on consumption cos of higher prices, Y decrease
Automatic stabilisers definition
Automatic stabilisers are items in the budget that automatically changes when the economic condition changes
These changes help to stabilise the economy by reducing the fluctuations in the AD
Automatic stabilisers (2)
Progressive income tax
A tax rate that increases with higher income bracket
During recession (Prevents C & AD from falling too low)
As people’s income decreases, they now pay less taxes → prevents their Y from falling too low
During economic expansion (Prevents C & AD from increasing too high)
People will now pay more taxes than before → disposable income Yd will be prevented from increasing too much
Automatic stabilisers (1)
Unemployment compensation
During recession (prevent C & AD from falling too low)
Unemployed, loses income → reduces spending → income of someone else to fall → multiplier process begins to contract the level of income
Unemployed receive some income to spend → reduction in spending will be less → multiplier process that reduces income will not be as great
During inflation (prevent C & AD from increasing too high)
Employed → have to contribute to the unemployment benefits fund → decrease income available to spend
