Macro Unit 6- Fiscal Policy

Question 1

What is fiscal policy?

Answer 1

Fiscal policy involves the use of government spending, direct and indirect taxation and government borrowing to affect the level and growth of AD in the economy- output and jobs.

Fiscal policy is also used to change the patten of spending on goods and services and influences consumption e.g. spending on healthcare (merit goods) or demerit goods.

Fiscal policy is also a means by which a redistribution of income and wealth can be achieved for example by changing tax rates. Fiscal policy looks at improving the tax revenue for government spending.

Question 2

What are the three main areas of government spending?

Answer 2

1. Transfer payments- welfare payments made to benefit recipients such as state pensions
2. Current spending- spending on merit/public goods
3. Capital spending- infrastructure spending such as spending on new roads.

Question 3

What is government debt?

Answer 3

The total amount borrowed by lenders and owned by the government which has accumulated over the years and needs to be paid back with interest.

Question 4

What are the causes of a fiscal budget deficit?

Answer 4

1. Government spending increases e.g. increased benefits due to high unemployment
2. Tax rates/revenue decreases e.g. due to a recession taxed my be lowered

Question 5

Why is public debt used in the short run to solve a fiscal budget deficit?

Answer 5

• Countries get extra funds to invest in their economic growth,
• public debt (government debt) improves the standard of living in a country because it allows the government to build new roads and bridges, improve education and job training and provide pensions.

Question 6

What are the consequences of large debts?

Answer 6

1. Opportunity cost of interest payments
2. Risk of credit downgrades
3. Confidence issues regarding re-financing
4. Risk of crowding out

Question 7

What is the opportunity cost of interest payments?

Answer 7

Refers to payments which are determined by the interest rate on an account. For example, the forgone alternative example would be high debt rates means you cannot spend as much elsewhere e.g. on healthcare.

Question 8

What’s the problem with the opportunity cost of interest payments?

Answer 8

This can be a problem for an economy because less money is being spent on services such as the NHS which our economy relies on for example, if their is less spending on the NHS then many people will be unable to pay for treatments thus taking time off work. Resulting in less disposable income so less consumption reducing firm’s profits worsening the economy. Overall, this will cause more demand for welfare payments.

Question 9

What is a credit rating?

Answer 9

It is a quantified assessment of the credit worthiness of a borrower with respect to a debt of borrowed money. It can be assigned to anyone that wants to borrow money- an individual, corporation or government. It shows if a consumer or business will be able to repay the borrowed money plus the added interest

Question 10

Who rates the government?

Answer 10

1. Fitch
2. Moodys
3. Standard and Poors

Question 11

If a country is being downgraded on their credit rating, what does this mean?

Answer 11

Other countries will be less willing to lend money as they are a high risk as they won’t be able to pay the money back

Question 12

How can a credit downgrade result in slower economic growth?

Answer 12

May make our ability to borrow money on the market harder and so we will have less money to spend on transfer payments, and current and capital spending

Question 13

1. What is refinancing?

2. What is the purpose of refinancing?

Answer 13

1. Refinancing is the process of replacing an existing loan with a new loan.
2. The purpose is for people to refinance their mortgage in order to reduce their monthly payments, lower their interest rate, or change their loan program from an adjustable rate mortgage to a fixed rate mortgage.

Question 14

Why is it good to have a high credit rating?

Answer 14

High credit scores means people can secure more favourable contract terms and lower interest rates

Question 15

What is the crossing out effect?

Answer 15

It is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending.

Question 16

When does crowding out happen? How does it affect AD?

Answer 16

Crowding out happens when there is a rapid growth of government spending leads to a transfer of scarce productive resources from the private sector to the public sector where productivity might be lower. This means that AD in the private sector increases due to there being more injections into the circular flow from government spending boosting the economy.

Question 17

What are the reasons crowding out takes place?

Answer 17

1. Rises in real interest rates
2. High government spending
3. High taxes

Question 18

What is crowding in?

Answer 18

Government borrowing can actually increase demand by generating employment, thereby stimulating private spending.

Question 19

Why does inflation make it easier for the government to pay back debt?

Answer 19

As inflation increases, interest rates have decreased and whilst this is bad for bond holders, the government debt has reduced as they do not have to rape as high an interest.

Question 20

What is discretionary fiscal policy?

Answer 20

Refers to government policy that alters government spending or taxes. It’s purpose is to expand or shrink the economy as needed. It can be used to increase AD.

Question 21

What is contractionary discretionary fiscal policy?

Answer 21

When an economy is in a state in which growth is getting out of control and therefore causing inflation and asset price bubbles, a contractionary fiscal policy can be used to rein in this inflation- to bring it to a more sustainable level. A contractionary discretionary policy will lower government spending and/or increase taxation.

Question 22

What are some limitations of discretionary fiscal policy?

Answer 22

1. Expansionary bias- no government or politician would implement a contractionary policy, so this means that expenditure will keep rising and taxes would probably not rise too.
2. Execution- contractionary policy is difficult to implement because no one wants to cut spending.
3. Crowding out- occurs when a big government borrows money which leads to higher interest rates for the private sector so less private investment.

Question 24

What is expansionary discretionary fiscal policy?

Answer 24

This kind of policy involves decreasing taxes and/or increasing government spending. It is typically used during a recession.

Question 25

What is an automatic fiscal stabiliser?

Answer 25

Refer to how fiscal policy instruments will influence the rate of GDP growth and help counter swings in the business cycle.

Question 26

During high economic growth what can automatic stabilisers help to reduce?

Answer 26

They will help to reduce the growth rate and avoid the risks of an unsustainable boom and accelerating inflation. With higher growth, the government will receive more tax revenues

Question 27

During a recession what can automatic stabilisers help to reduce?

Answer 27

Economic growth becomes negative but automatic stabilisers will help to limit the fall in growth. With lower incomes people pay less tax and government spending on unemployment benefits increase. The result is an automatic increase in government borrowing with the state sector injecting extra demand into the circular flow.

Question 28

During a recession, what do automatic stabilisers do?

Answer 28

With lower income, people pay less tax, and government spending on unemployment benefits will increase.

Question 29

What is the relationship between economic depth and government borrowing?

Answer 29

In periods of positive economic growth we see low levels of annual government borrowing.

Question 30

What does Keynes argue happens in a recession?

Answer 30

Confidence falls and the private sector cut back on spending and investment. Therefore we see a rise in private savings and a fall in AD. This is why Keynes advocates government borrowing to make use of the surplus savings. Keynes argues that automatic stabilisers may not be enough, and the government should specifically find public sector projects to inject money into the circular flow known as the discretionary fiscal policy.