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
- Risk of Inflationary Pressures
Expansionary fiscal policy involves increasing government spending or reducing taxes to stimulate demand → This leads to a rise in aggregate demand (AD) as consumers and businesses have more disposable income → If the economy is already close to or at full capacity, demand-pull inflation occurs because supply cannot keep up with demand → Rising inflation erodes purchasing power, increases business costs, and may force the central bank to raise interest rates, which could offset the policy’s benefits. - Higher Budget Deficits and National Debt
Governments often borrow money to finance expansionary fiscal policy, leading to a higher budget deficit → This increases the national debt, which must be repaid in the future → If borrowing levels become unsustainable, the government may need to cut spending or raise taxes in the future, reducing the long-term benefits of the initial stimulus → Higher debt may also reduce investor confidence, leading to higher borrowing costs for the government, further worsening fiscal conditions. - Crowding Out Effect
When the government borrows more to finance fiscal expansion, it increases the demand for loanable funds, leading to higher interest rates → As borrowing costs rise, private sector investment declines, as businesses and consumers find it more expensive to finance new projects or purchases → This is known as the crowding-out effect, where government spending replaces, rather than complements, private investment → This reduces the overall effectiveness of the policy in stimulating growth. - Time Lags in Implementation
Fiscal policy changes take time to implement, as government budgets, spending plans, and tax adjustments must go through legislative processes → Even once approved, the effects take time to filter through the economy, as consumers and businesses gradually adjust their spending → If fiscal stimulus is introduced too late, it may overheat the economy during a recovery phase or be ineffective if economic conditions change → This delay reduces the policy’s responsiveness to economic shocks. - Effectiveness Depends on Economic Conditions
Expansionary fiscal policy is most effective when there is spare capacity in the economy → However, if businesses lack confidence due to uncertainty or external shocks, they may not respond to tax cuts or government spending as expected → Similarly, if consumers save rather than spend their extra disposable income (e.g., in a recession), the multiplier effect weakens, making the policy less effective → This uncertainty means the policy does not always guarantee economic growth.
Ricardian Equivalence – Consumers May Not Spend More
If the government increases spending through borrowing, rational consumers may anticipate higher future taxes to repay the debt → Instead of spending their additional disposable income (from tax cuts or stimulus), consumers may save more, fearing future tax burdens → This means the expansionary fiscal policy fails to increase AD significantly, as households adjust their behavior in response to future expectations → The result is that fiscal stimulus has a weaker or even negligible effect on economic growth.
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
intentional government policies to increase or decrease government spending or taxation
what are automatic stabilisers
fiscal policy tools to influence GDP and counter fluctuations in the economic cycle
what are automatic stabilisers
- means government
spending/taxation vary - without direct government decision-making
- over the course of the economic
cycle - built into the means-tested welfare support and progressive tax bands
what are the automatic stabilisers
- progressive income tax systems
- welfare benefits
how does a progressive income tax help in a boom
- 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
what is the average rate of tax
the amount of income tax paid as a proportion of total income
how would welfare benefits help in a boom
- in a boom, unemployment will be low, government spending on unemployment benefits will be low, risk of demand pull inflation is lower
what role does a progressive income tax play in a recession
- 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
what role does welfare benefits play in a recession
in a recession, unemployment will be higher, govt spending on unemployment benefits will be higher, helping increase AD and prevent a deep recession
how do automatic stabilisers help w expansionary fiscal policies
if the role of the automatic stabilisers in a recession in particular, are very large, it reduces the need for discretionary fiscal policy
how do automatic stabilisers help w expansionary fiscal policy
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
what does the laffer curve state
- 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
what is an efficient tax rate
- the point where the government is maximising its revenue collected by tax
why would tax revenue decrease after the efficient tax rate
- 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
what is tax evasion
- not declaring all of your income, illegal
what is tax avoidance
- finding loopholes in the tax system, so you don’t pay as much tax as you would otherwise, legal
who argues the crowding out effect
- classical economists
what was the total govt spending in 2015
745 billion, 43% of GDP
- 50 billion was on capital spending, 22% on public services like education
how to increase short run growth
- expansionary fiscal/monetary policies
fiscal - increasing G, reducing tax, monetary - decreasing IR/ quantitative easing
evaluating ways to increase short run growth
- conflict of objectives - inflation (demand pull)
- size of output gap - negative gap means higher risk of inflation
- consumer and business confidence
- time lags
what is the crowding out effect
occurs when increased govt spending leads to a reduction in private sector investment or consumption due to higher interest rates or limited resources
crowding out effect in steps
- 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
crowding out effect in steps
- 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
What is the role of the Bank of England’s Monetary Policy Committee (MPC)
responsible for setting the official bank rate (interest rates) to achieve the government’s inflation target, typically aiming for a 2% inflation rate. The MPC can also implement quantitative easing when necessary.
What were the demand-side policy responses during the Great Depression and the Global Financial Crisis of 2008?
1️⃣ Great Depression (1929-1939)
1. Government Increase in Public Spending (New Deal Programs) → Boosted Aggregate Demand → Increased Employment & Economic Activity → Stimulated Recovery
The U.S. government increased public spending under President Franklin D. Roosevelt’s New Deal.
This included investment in infrastructure projects, such as roads, schools, and bridges, to create jobs and increase demand for goods and services.
The increased employment boosted consumer spending, which in turn stimulated further demand for goods and services, aiding in economic recovery.
📌 Evaluation: Public spending alone didn’t solve the Depression; the U.S. entry into World War II later played a crucial role in full recovery.
- Monetary Policy (Lower Interest Rates) → Increased Borrowing & Investment → Boosted Consumption & Demand for Goods
The Federal Reserve slashed interest rates to make borrowing cheaper, encouraging businesses to invest in new projects.
Lower interest rates also led to increased consumer spending on big-ticket items, such as cars and homes, stimulating demand across industries.
As businesses invested more, this created jobs, further boosting consumer confidence and spending.
📌 Evaluation: The Fed’s actions were somewhat limited by the global gold standard and the reluctance to increase the money supply earlier.
- Agricultural Support & Price Floors → Increased Farm Income → Higher Consumption & Demand → Boosted Rural Economy
The U.S. government introduced programs to provide price supports and subsidies to farmers, ensuring they received stable income during the crisis.
These measures helped increase purchasing power in rural areas, stimulating demand for goods and services, thus contributing to broader economic recovery.
📌 Evaluation: While the programs helped rural areas, the overall recovery remained slow until the U.S. engaged in wartime production.
2️⃣ Global Financial Crisis (2007-2008)
1. Monetary Policy (Interest Rate Cuts) → Lower Borrowing Costs → Increased Investment & Consumption → Stimulated Economic Growth
Central banks, including the Federal Reserve and European Central Bank, cut interest rates dramatically to encourage borrowing and investment.
The aim was to make credit cheaper, allowing businesses and consumers to spend more, thereby stimulating demand in the economy.
Lower rates encouraged borrowing for mortgages and loans, supporting demand for homes and other consumer goods.
📌 Evaluation: Although effective in some regions, interest rate cuts were less impactful in areas with credit contraction or banking issues, particularly in Europe.
- Government Fiscal Stimulus (Direct Spending & Tax Cuts) → Increased Aggregate Demand → Economic Activity & Job Creation
Governments worldwide, particularly in the U.S. and China, introduced massive fiscal stimulus packages.
In the U.S., the American Recovery and Reinvestment Act (ARRA) included direct government spending on infrastructure projects and tax cuts for individuals and businesses.
This increased demand for goods and services, directly stimulating economic activity and creating jobs across sectors like construction and manufacturing.
📌 Evaluation: While fiscal stimulus provided a short-term boost, the long-term sustainability of the recovery remained uncertain, with some arguing that the programs were not adequately targeted.
- Bank Bailouts & Financial Sector Support → Restored Confidence in the Banking System → Resumed Lending → Stimulated Economic Growth
Governments provided financial support and bailouts to struggling banks and financial institutions to stabilize the financial system.
This action was crucial in restoring confidence, ensuring banks could resume lending to consumers and businesses, which had dried up during the crisis.
With credit flowing again, businesses could invest in new projects, and consumers could access loans for homes and vehicles, helping to stimulate demand.
📌 Evaluation: While necessary to avoid complete financial collapse, bank bailouts were controversial, as critics argued that they led to moral hazard and increased inequality.
- Quantitative Easing (QE) → Increased Money Supply → Lower Long-Term Interest Rates → Boosted Investment & Demand
Central banks, such as the Federal Reserve, employed quantitative easing (QE) by purchasing government bonds and mortgage-backed securities to increase the money supply and lower long-term interest rates.
This action aimed to reduce borrowing costs further and stimulate investment by businesses and consumers.
With cheaper credit, businesses could borrow more to invest in capital, and consumers were more likely to spend, thereby supporting aggregate demand.
📌 Evaluation: The effectiveness of QE was debated, as it primarily benefited financial markets, potentially increasing inequality without providing enough direct support to the broader economy.
