Monetary and Fiscal policies Flashcards
what is fiscal policy
a macroeconomic policy which involves changes to government spending, borrowing and taxation in order to influence AD in the economy
types of fiscal policy
exapansionary and contractionary
what is expansionary fiscal policy
- policies used to increase AD, often used before a recessioneg - reducing tax and increasing government spending
what is contractionary fiscal policy
- policies used to reduce AD
- usually used before a boom to lower levels of inflation (reducing AD)
- eg by increasing tax and reducing govt spending
when would expansionary fiscal policy be used
- to boost growth
- to reduce unemployment
- to increase inflation
- redistribute income
when would contractionary fiscal policy be used
- to reduce inflation
- reduce budget deficit/national debt
- redistribute income
- reduce current account deficit (exports)
what is the multiplier effect
the idea that an increase in AD will lead to higher incomes in the economy leading to more spending, higher AD
examples of expansionary fiscal policy
- reduction in income tax for those in a higher income or lower - this will increase the disposable income of households in the economy, increase the marginal propensity to consume, which will increase consumption in the AD equation
- reduction in corporation tax - tax on business reduces, retained profit increases, which may increase their marginal propensity to invest, increasing investment in the AD equation
- reduction in regressive tax - eg a reduction in VAT may increase disposable income for the poor more than for the rich, and because the poor have a larger marginal propensity to consume, consumption will increase
- increased govt spending in things like education healthcare etc, increases G in the AD equation
how can expansionary fiscal policies shift LRAS to the right
- a reduction in income tax could incentivise the inactive to become active and join the labour force, improving quantity of labour, increasing LRAS
- also for those already in labour force, there is incentive to work harder to earn more because they can keep more of their income as disposable income, increase in the quality of labour, rightward shift of LRAS
- reduction in corporation tax, higher investment = increased quality and quantity of capital and productive efficiency in the economy
- increase in govt spending, could boost the productivity of labour therefore boost the quality of labour
- govt spending on infrastructure could also increase the productive efficiency in the economy and also the quantity of capital
problems with using expansionary fiscal policy
- higher demand pull inflationary pressure
- current account deficit as there are higher incomes which may lead to higher spending on imports
- govt finances are likely to worsen with expansionary fiscal policies, national debt may increase, oppurtunity cost could occur w paying off debt
- if households in the economy know that the govt can’t afford expansionary fiscal policy in the form of an income tax cut, households may save the tax cut now, expecting a tax rise in the future, known as Ricardian equivalence, in that sense an income tax cut will not boost the economy
- crowding out effect - this is where government spending is heavily borrowing fuelled. debt fuelled govt spending can reduce private sector investment
- x efficiency- govt spending could be wasteful, there is a risk of excess govt spending and excess costs
- time lags - govt spending on things like infrastructure will mean rounds of govt spending so you won’t get the boost of AD until the project is finished. also tax cuts will take time to feed into the economy
why might debt fuelled govt spending hurt the private sector
- if govt spending is highly debt fuelled, demand for loanable funds increase, which pushes up equilibrium interest rates, more expensive for private businesses to borrow, more expensive to fund their investment, less investment, bad for long term growth rate and also may cause dependency on govt spending to boost economic growth
evaluation points for expansionary fiscal policy
- size of the output gap - if the economy is close to full employment, with a small negative output gap, it means the expansionary fiscal policy is likely to be ineffective in boosting growth and reducing unemployment. however if there is a large negative output gap, the policy has greater potential to be efficient in boosting growth
- size of the multiplier - if the multiplier is large, the impact of the policy is likely to be greater, but if it is large, there is less need for very heavy expansionary policy because the multiplier effect will do majority of the work
- consumer and business confidence - if confidence is low, income tax cut may be saved and not spent, businesses might not use increased retained profit to invest
- state of govt finances before policy is applied - high budget deficits or high national debt, policy may not be able to be afforded vice versa
- long run returns to the govt through higher tax revenues, eg govt spending on education etc provides long run growth and benefits to the economy, greater economic activity and greater returns
- lagger curve idea - income tax cut may lead to higher tax revenue because of the incentive effects
- role of the automatic stabilisers - if there are strong automatic stabilisers in the economy, it reduces the needs for the expansionary policy in a recession. this is because automatic stabilisers help to support output in a recession. if they do their job well, there isn’t a need for discretionary fiscal policy
crowding out effect vs crowding in - keynesian economists disagree w the crowding out effect because in a recession, there is a glut of savings therefore the chance of equilibrium interest rates being pushed up via debt fuelled govt spending is very low
- govt spending could crowd in the private sector. this is where govt spending creates demand in the economy and generates economic activity which incentivises private sector businesses to tap into that and invest and grow their business cos there is greater profit potential when there is higher demand in the economy
- classical view of self correcting economy in a recession - wages will fall and we will return to full employment on its own therefore there is no need for debt fuelled govt spending
what is discretionary fiscal policy
expansionary fiscal policy on top of the automatic stabilisers in an economy
what are automatic stabilisers
fiscal policy tools to influence GDP and counter fluctuations in the economic cycle
