Monetary and Fiscal policies

Question 1

what is fiscal policy

Answer 1

a macroeconomic policy which involves changes to government spending, borrowing and taxation in order to influence AD in the economy

Question 2

types of fiscal policy

Answer 2

exapansionary and contractionary

Question 3

what is expansionary fiscal policy

Answer 3

• policies used to increase AD, often used before a recessioneg - reducing tax and increasing government spending

Question 4

what is contractionary fiscal policy

Answer 4

• 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

Question 5

when would expansionary fiscal policy be used

Answer 5

• to boost growth
• to reduce unemployment
• to increase inflation
• redistribute income

Question 6

when would contractionary fiscal policy be used

Answer 6

• to reduce inflation
• reduce budget deficit/national debt
• redistribute income
• reduce current account deficit (exports)

Question 7

what is the multiplier effect

Answer 7

the idea that an increase in AD will lead to higher incomes in the economy leading to more spending, higher AD

Question 8

examples of expansionary fiscal policy

Answer 8

• 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

Question 9

how can expansionary fiscal policies shift LRAS to the right

Answer 9

• 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

Question 10

problems with using expansionary fiscal policy

Answer 10

• 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

Question 11

why might debt fuelled govt spending hurt the private sector

Answer 11

• 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

Question 12

evaluation points for expansionary fiscal policy

Answer 12

• 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

Question 13

what is discretionary fiscal policy

Answer 13

expansionary fiscal policy on top of the automatic stabilisers in an economy

Question 15

what are automatic stabilisers

Answer 15

fiscal policy tools to influence GDP and counter fluctuations in the economic cycle

Question 16

what do automatic stabilisers do in a boom and in a recession

Answer 16

they will push in demand so the economy doesn’t overheat and in a recession they will come in to support demand to prevent a deep recession

Question 17

what are the automatic stabilisers

Answer 17

• progressive income tax systems
• welfare benefits

Question 18

how does a progressive income tax help in a boom

Answer 18

• increased growth will lead to increased incomes, workers are paid more, and be pushed into higher tax bands and will be paying larger amounts of tax, increased average rate of tax, slows down consumption and slows down AD rise

Question 19

what is the average rate of tax

Answer 19

the amount of income tax paid as a proportion of total income

Question 20

how would welfare benefits help in a boom

Answer 20

• in a boom, unemployment will be low, government spending on unemployment benefits will be low, risk of demand pull inflation is lower

Question 21

what role does a progressive income tax play in a recession

Answer 21

• in a recession, incomes are lower, workers move into lower tax brackets and pay less tax, reducing ART, preventing large decreases in consumption, reducing how much AD falls by

Question 22

what role does welfare benefits play in a recession

Answer 22

in a recession, unemployment will be higher, govt spending on unemployment benefits will be higher, helping increase AD and prevent a deep recession

Question 23

how do automatic stabilisers help w expansionary fiscal policies

Answer 23

if the role of the automatic stabilisers in a recession in particular, are very large, it reduces the need for discretionary fiscal policy

Question 24

how do automatic stabilisers help w expansionary fiscal policy

Answer 24

if the role of the automatic stabilisers in a recession in particular are very large, it reduces the need for discretionary fiscal policy
- govts dont have to spend a huge amount of money, or cut taxation massively

Question 25

what is discretionary fiscal policy

Answer 25

expansionary fiscal policy on top of the automatic stabilisers

Question 26

what does the laffer curve state

Answer 26

• increasing taxes will increase tax revenue up to a point
• however if taxes increase beyond a point (efficient tax rate), the amount of tax revenue collected by the government will start to decrease

Question 27

what is an efficient tax rate

Answer 27

• the point where the government is maximising its revenue collected by tax

Question 28

why would tax revenue decrease after the efficient tax rate

Answer 28

• very high taxes may reduce incentive to work hard, disincentivise being entrepreneurial
• workers may substitute their hard work for leisure, as working extra hard/long hours is pointless as the income they earn is being taxed away
• entrepreneurs take less risk
• emigration - if taxes rise, incentive for high valued workers, best in the country to stay decreases, if taxes are lower abroad, incentive to migrate increases, and most of the time these are the biggest tax payers to the govt, so this will result in a lower tax revenue
• tax evasion, tax avoidance - increasing tax promotes these types of behaviour, which will decrease tax rev

Question 29

what is tax evasion

Answer 29

• not declaring all of your income, illegal

Question 30

what is tax avoidance

Answer 30

• finding loopholes in the tax system, so you don’t pay as much tax as you would otherwise, legal

Question 31

who argues the crowding out effect

Answer 31

• classical economists

Question 32

what was the total govt spending in 2015

Answer 32

745 billion, 43% of GDP
- 50 billion was on capital spending, 22% on public services like education

Question 33

how to increase short run growth

Answer 33

• expansionary fiscal/monetary policies
  fiscal - increasing G, reducing tax, monetary - decreasing IR/ quantitative easing

Question 34

evaluating ways to increase short run growth

Answer 34

• conflict of objectives - inflation (demand pull)
• size of output gap - negative gap means higher risk of inflation
• consumer and business confidence
• time lags

Question 35

what is the crowding out effect

Answer 35

occurs when increased govt spending leads to a reduction in private sector investment or consumption due to higher interest rates or limited resources

Question 36

crowding out effect in steps

Answer 36

• when govt borrows money to finance its spending, it competes with the private sector for available funds in the financial markets
• this can drive up interest rates
• cost of borrowing for businesses and individuals increase, discouraging private investment and spending
• govt spending can also absorb resources that might otherwise be used by the priv sector
• this reduces the availability of these resources for private enterprises
• reduces private sector activity, leading to lower economic growth

Question 37

crowding out effect in steps

Answer 37

• when govt borrows money to finance its spending, it competes with the private sector for available funds in the financial markets
• this can drive up interest rates
• cost of borrowing for businesses and individuals increase, discouraging private investment and spending
• govt spending can also absorb resources that might otherwise be used by the priv sector
• this reduces the availability of these resources for private enterprises
• reduces private sector activity, leading to lower economic growth