Fiscal Policy

Fiscal Policy

1. Involves the government changing levels of Taxation and Government spending in order to influence AD and the level of economic activity

   • AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)
     • Government spending
     • Investment
     • Consumer spending
     • eXports-iMports

2. PURPOSE

   • Stimulate economic growth in a period of recession
   • Keep inflation low (>2% target)
   • Stabilise economic growth
     • Avoid a boom and bust economic cycle

3. EXPANSIONARY

   • Increasing AD
     • Increasing G or reducing T
       • Reducing T will increase C as consumers will have more disposable Y
         • This will tend worsen the government budget deficit and the government will need to increase borrowing.

4. DEFLATIONARY

   • Decreasing AD
     • Cut G and Increase T
       • Higher T will decrease C
         • Deflationary Fiscal policy will tend to cause an improvement in the government budget deficit.

5. 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).

   • (Government borrowing also rose because of the recession leading to lower tax revenue)
     • 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.
       • This involved spending limits. This austerity measures were a factor in causing lower economic growth in 2011 and 2012.

6. The multiplier effect.

   • When an increase in injections causes a bigger final increase in Real GDP.
     • Injections (J) – This is an increase of expenditure into the circular flow, it includes govt spending(G), Exports (X) and Investment (I)
     • 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)

7. CRITICISMS

   • The government may have poor information about the state of the economy so may not be able to identify what it needs
   • Time lags
   • Crowding out
     • 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.
   • Inefficient
     • 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
   • Higher borrowing costs. Debt repayment

8. EVALUATION

   • It depends on the size of the multiplier.
   • 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.
     • Higher government spending will not cause crowding out because the private sector saving has increased substantially.
   • It depends on other factors in the economy. .
     • 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
   • Bond yields

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