Topic no. 12: Fiscal Policy Flashcards
Understand: - What role does the government play in an economy - Sources of Government Revenue - Areas of Government Expenditure - The Government Budget - Discretionary FP - Expansionary and Contractionary FP - Effects of a change in G and T - Evaluation of FP - Automatic Stabilisers
What role does the government play in an economy?
Private sectors (C & I) make their decisions based on personal interest → Combined decisions may be insufficient (unemployment) or excessive (inflation) → C & I cannot be counted upon to spend more when AD is too low or spend less when AD is too high → Government need to step in to stabilise the economy at/near full employment → Using fiscal policy (use of government budget) or monetary policy (△ money supply)
What is fiscal policy?
Changes in government spending (G) or taxes (T) to reach the desired Yf/income level.
[G or T can take the form of discretionary fiscal policy. Changing G and T will change the AD which will then change the income level.]
What are the sources of government revenue?
a) Main source: Taxes
[e.g. direct taxes (income tax, property tax) and indirect taxes(GST)]
b) Non-tax revenue: investment income, income from sales of goods & services, repayment of government loans
What are the areas of government expenditure?
Defence and justice, social & community services, economic services & servicing of its public debt.
What is the government’s budget?
Shows its expenditure and revenue for a particular year.
[Status of budget shown by difference between revenue and expenditure]
Budget = Revenue (T) - Expenditure (G)
T > G → Budget surplus
T < G → Budget deficit
T = G → Balanced budget
What are the discretionary fiscal policy?
a) Expansionary fiscal policy
b) Contractionary fiscal policy
What is expansionary fiscal policy?
When economy is in a recession raise the expenditure and/or lowering taxes. Resulting in ↑ AD and output.
↑ expenditure → AD will shift to the right
Lower tax → disposable income/after-tax income [Y - T]
T = Lump sum tax (A tax of a fixed/constant amount that is paid regardless of income level)
↓ T → After tax income ↑ (Disposable income) → C will ↑ → AD will shift to the right → Output ↑
What is contractionary fiscal policy?
When economy is in an inflationary situation lower G and/or increase taxes. Resulting in AD and output decreasing.
↓ G → AD will shift to the left
↑ Tax → After tax income ↓ → C will ↓ → AD will shift to the left → output ↓
How to calculate the effects of change in G and T?
△ Y = (1/MPS) x △G
(Increase G by $50b)
△ Y = (1/0.25) x $50b
△ Y = $20b
(Decrease T by $50b)
△ Y = (-MPC/MPS) x △ T
△ Y = (-0.75/0.25) x - $50b
△ Y = $150b
What is the evaluation of fiscal policy?
a) Timing problem
- Recognition lag [Time needed to identify stage of business cycle a country is at before deciding on appropriate policy to adopt]
- Administrative lag [Time needed to obtain approval from various parties to change taxes or government spending]
- Operational lag [Fiscal policy enacted now requires time via the multiplier to work through economy and affect income. By then, there may be changes in economic conditions so that the opposite fiscal policy is required]
b) Political consideration
[Adoption of expansionary FP, compromising an ↑ in G and/or a ↓ in T, make government more popular.]
c) Crowding-out effect
[Reducing impact of FP: Govt borrow to stimulate economy → demand for funds in country ↑ → interest rate ↑ (more people borrow) → investment & consumption ↓ (too expensive to borrow) → Government tries to ↑ spending → AD shifts right → interest rate ↑ → C & I ↓ → AD shifts left (Negative impact on consumption and investment)]
d) Inflation
Expansionary FP → ↑ AD and Y → inflation → reduces impact of AE
[↑ G → ↑ AD → inflation → people cut back on consumption due to higher prices → Y ↓]
What are automatic stabilisers?
Items in the budget that automatically changes when economic condition changes. Help to stabilise the economy by reducing fluctuations in AD.
[Times are bad → GDP will not ↓ too low.]
[Times are good → GDP will not ↑ too high]
What are two examples of automatic stabilisers?
a) Unemployment compensation
i) Unemployment Compensation during Recession
[Prevent C & AD from falling too low during Recession]
ii) Unemployment Compensation during Inflation
[Prevent C & AD from rising too high]
b) Progressive Income Tax
[A tax rate that ↑ with higher income bracket → amount of tax paid ↑ as income ↑]
i) Progressive income tax during Recession
(Prevents C & AD from ↓ too low)
[People’s income ↓ → pay less tax → prevents income from ↓ too low]
ii) Progressive income tax during Inflation
(Prevents C & AD from ↑ too high)
[People pay more taxes than before → after tax income/disposable income will be prevented from ↑ too much]
