Macro 10 - Fiscal policy

Question 1

What is public expenditure?

Answer 1

Public expenditure is spending by the government including capital and current spending and transfer payments

Question 2

What are the three main reasons for government spending?

Answer 2

1- Overcoming market failure and improving efficiency
2- Redistributing income and wealth
3- Macro-economic management

Question 3

What are some of the factors that affect the level of government spending?

Answer 3

• Changing incomes
• Changing age distribution and population size
• Political priorities
• The trade cycle

Question 4

Define the term ‘automatic stabilisers’

Answer 4

Automatic stabilisers relate to the fact that some forms of government expenditure and revenues from some taxes change automatically and in line with changes in GDP and the state of the economy

Question 5

Define the term ‘discretionary fiscal policy’

Answer 5

Discretionary fiscal policy refers to deliberate changes in taxes and public expenditure designed to achieve the government’s macroeconomic objectives

Question 6

How do automatic stabilisers work in a boom?

Answer 6

During a boom, the automatic stabilisers create a budget surplus as tax revenue increases and government spending on benefits falls

Question 7

How do automatic stabilisers work in a recession?

Answer 7

During a recessions, government spending will increase because the government will pay out more benefits and receive less tax revenue due to unemployment

Question 8

Define the term ‘fiscal policy’

Answer 8

Fiscal policy involves the use of government spending and taxation to influence the overall level of aggregate demand in an economy to achieve macroeconomic objectives

Question 9

What are the two types of fiscal policy?

Answer 9

• Expansionary/reflationary fiscal policy
• Contractionary/deflationary fiscal policy

Question 10

What is expansionary fiscal policy?

Answer 10

Expansionary fiscal policy refers to using fiscal tools in order boost aggregate demand with the purpose of improving macroeconomic performance. This will include reducing taxes, increasing government spending and government borrowing

Question 11

What are some examples of expansionary fiscal policy?

Answer 11

1- Cutting income tax to increase disposable income and consumer spending
2- Cutting corporation tax to increase retained profits and business investment
3- Cutting indirect taxes to reduce prices and encourage consumer spending
4- Government spending on projects to create output, jobs and expenditure

Question 12

When is expansionary fiscal policy likely to be used?

Answer 12

Expansionary fiscal policy is likely to be used during a recession or when there is a negative output gap. It will increase economic growth and reduce unemployment but will also increase inflation and worsen the current account of the balance of payments

Question 13

When is contractionary fiscal policy likely to be used?

Answer 13

Contractionary fiscal policy is likely to be used during a boom or when there is a positive output gap. It will reduce economic growth and increase unemployment but it will also reduce price levels and improve the current account of the balance of payments

Question 14

What is contractionary fiscal policy?

Answer 14

Contractionary fiscal policy involves using fiscal tools in order to reduce aggregate demand with the purpose of improving macroeconomic performance. This includes raising taxes, cutting government spending and reducing government borrowing

Question 15

What are some benefits of fiscal policy?

Answer 15

• It can help manipulate aggregate demand by increasing or decreasing the government component of aggregate demand and consumption and investment meaning its impacts can be wide reaching
• Though its impact is largely on the demand side it can help improve aggregate supply
• Fiscal policy can be targeted at specific industries or regions whereas monetary policy cannot

Question 16

What are some drawbacks of fiscal policy?

Answer 16

• Government finances can be a constraint of expansionary fiscal policy. Spending more than is received in tax revenue increases the budget deficit and therefore national debt
• There are huge time lags, it can a long time for policies to take effect
• Unintended impacts on incentives

Question 17

What does the effectiveness of fiscal policy depend on?

Answer 17

• Confidence
• The size of the multiplier effect
• What the government spends money on/ which taxes are changed

Question 18

What are some benefits of high levels of government spending?

Answer 18

1- Public expenditure on education, infrastructure and healthcare can increase productivity shifting SRAS to the right and LRAS to the right
2- Increased public expenditure is an injection into an economy’s circular flow. It will therefore increase AD and lead to economic growth multiplier effect will cause more growth
3- If government spending is on goods and services such as pensions, transfer payments, health and education there will be greater income equality
4- Government spending can correct market failure

Question 19

What are some drawbacks of high levels of government spending?

Answer 19

1- Low productivity: The public sector is often considered to be less efficient than the private sector as it lacks the profit motive and therefore has less incentive to efficient
2- Crowding out: This occurs when extra government spending leads to lower private sector spending
3- Impact on government finances: High spending can have a detrimental impact on the government’s finances. It can lead to fiscal/budget deficits and then high levels of national debt over time

Question 20

What are the two types of crowding out?

Answer 20

• Resource crowding out
• Financial crowding out

Question 21

What is resource crowding out?

Answer 21

Resource crowding out occurs when the economy is at full employment and public sector spending means there is a lack of resources available for the private sector

Question 22

What is financial crowding out?

Answer 22

Financial crowding out occurs when increased public sector spending is financed by borrowing. This increases the demand for loanable funds and pushes up interest rates. This reduced the incentive and ability of private sector firms to invest

Question 23

Why may crowding out not occur?

Answer 23

• In recession demand for funds from private sector may be low so there may be little opportunity cost of the government borrowing
• Government spending on grants, infrastructure etc could help the private sector in the long term
• Government spending creates work for the private sector

Question 24

What are the two types of fiscal budget deficits?

Answer 24

• Cyclical budget deficit
• Structural budget deficit

Question 25

Define the term ‘structural budget position’

Answer 25

A structural budget position is a government’s long term fiscal stance. This means their budget position over a whole period of the economic cycle including booms and/or recessions

Question 26

Define the term ‘cyclical budget position’

Answer 26

A cyclical budget position is a government’s fiscal stance in the short term. This is affected by where the economy is in the economic cycle. Automatic stabilisers are likely to create a surplus during a boom and a deficit during a recession

Question 27

Define the term ‘cyclical budget deficit’

Answer 27

A cyclical budget deficit is a budget deficit caused by an expansionary cyclical budget position

Question 28

Define the term ‘structural budget deficit’

Answer 28

A structural budget deficit is a budget deficit caused by an expansionary structural budget position (where spending is more than revenue in the long term)

Question 29

What is stamp duty?

Answer 29

Stam duty is a tax which must be paid when property is bought. The more properties being bought the more stamp duty will be paid to the government

Question 30

What are the causes of a structural fiscal deficit?

Answer 30

1- Demographic pressures
2- Discretionary fiscal policy
3- Debt interest
4- High levels of tax avoidance and tax evasion
5- High levels of income and wealth inequality

Question 31

What does the extent to which a fiscal deficit is a problem depend on?

Answer 31

• The country’s credit rating and the cost of borrowing
• Whether the budget deficit is cyclical or structural
• Whether the money is used for current or capital spending
• The size of the deficit as a percentage of GDP

Question 32

Define the term ‘national debt’

Answer 32

National debt is the accumulation of past budget deficits over multiple years

Question 33

What are the problems of having a high national debt?

Answer 33

1- It can create inter-generational inequality as it is later generations who are burdened with paying off the debt
2- National debt can force governments to make short-term decisions such as selling assets for sub optimal prices
3- National debt can lead to inflation as it involves more government spending than taxation
4- High levels of government debt can lead to high interest costs
5- Growing national debt can reduce a country’s credit rating

Question 34

What are the reasons why national debt may not be a cause for concern?

Answer 34

1- If inflation is occurring the real value of debt will fall over time
2- If economic growth is occurring at a greater rate than the rate of interest the value of debt as a percentage of GDP will fall
3- Debt may be necessary to bring an economy out of a recession more quickly
4- Debt can be used to fund long term capital spending to help growth in the future. This will make it easier to generate tax revenue in the future