Fiscal Policy

Involves the government changing levels of Taxation and Government spending in order to influence AD and the level of economic activity
1. AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)
  1. Government spending
  2. Investment
  3. Consumer spending
  4. eXports-iMports
PURPOSE
1. Stimulate economic growth in a period of recession
2. Keep inflation low (>2% target)
3. Stabilise economic growth
  1. Avoid a boom and bust economic cycle
EXPANSIONARY
1. Increasing AD
  1. Increasing G or reducing T
    1. Reducing T will increase C as consumers will have more disposable Y
      1. This will tend worsen the government budget deficit and the government will need to increase borrowing.
DEFLATIONARY
1. Decreasing AD
  1. Cut G and Increase T
    1. Higher T will decrease C
      1. Deflationary Fiscal policy will tend to cause an improvement in the government budget deficit.
In 2009, the government pursued expansionary fiscal policy. In response to a deep recession (GDP fell 6%) the government cut VAT in a bid to boost consumer spending. This caused a big rise in government borrowing (2009-10).
1. (Government borrowing also rose because of the recession leading to lower tax revenue)
  1. When the new coalition government came into power in May 2010, they argued the deficit was too high and then announced plans to reduce government borrowing.
    1. This involved spending limits. This austerity measures were a factor in causing lower economic growth in 2011 and 2012.
The multiplier effect.
1. When an increase in injections causes a bigger final increase in Real GDP.
  1. Injections (J) – This is an increase of expenditure into the circular flow, it includes govt spending(G), Exports (X) and Investment (I)
  2. Withdrawals (W) – This is leakages from the circular flow This is household income that is not spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M)
CRITICISMS
1. The government may have poor information about the state of the economy so may not be able to identify what it needs
2. Time lags
3. Crowding out
  1. An expansionary policy involves the government borrowing from the private sector to finance the increase in G. This depletes the private sector's funds and may reduce private investment.
4. Inefficient
  1. Free market economists argue that higher government spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to reduce spending in the future
5. Higher borrowing costs. Debt repayment
EVALUATION
1. It depends on the size of the multiplier.
2. It depends on the state of the economy. Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand.
  1. Higher government spending will not cause crowding out because the private sector saving has increased substantially.
3. It depends on other factors in the economy. .
  1. For example, if the government pursue expansionary fiscal policy, but interest rates rise and the global economy is in a recession, it may be insufficient to boost demand
4. Bond yields

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Fiscal Policy

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