Fiscal Policy - A2 Economics

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  • Created on: 15-06-13 10:02
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Fiscal Policy
Fiscal, monetary and supplyside policies are vital measures which authorities can
use to achieve their four main macroeconomic objectives: low unemployment,
sustainable growth, low inflation and equilibrium in the balance of payments.
Fiscal policy is the use of government taxation, spending and borrowing to influence
Objectives of fiscal policy
1. To improve macroeconomic performance e.g. reduce unemployment, improve BOP
or to reduce inflation.
2. Achieve a more desirable redistribution of income
3. Correct market failure e.g. provision of merit goods.
Crowding out
This occurs when increased government borrowing reduces investment. Financial crowding
out happens when government expenditure diverts financial resources away from the private
sector. If it spends more, it may need to borrow more ­ to raise this finance, it may need to
increase interest rates (to attract people to buy their bonds, which are essentially an IOU).
However, this deters private sector investment and consumption since it is more expensive
to borrow.
Use of fiscal policy to manipulate AD
Orthodox classical economists think that the government should maintain balanced budgets
­ whatever the state of the economy. Any extra spending would crowd out private sector
investment. If the government increased spending, this would displace private sector
spending, giving zero net impact (increase in G is offset by fall in C and I), whether in boom
or recession.
Keynes argued that crowding out did not take place in a depression. His views became the
accepted convention of the 1950s and 1960s. The postwar government used fiscal policy to
manage demand. Unemployment in those years was very low, therefore, it was the matter of
using fiscal levers, so the economy could be manipulated towards full employment.
In later years, there was a monetarist counter revolution against Keynes. They argued
theoretically, orthodox economists prior to the war were correct ­ crowding out neutralised
the impact of fiscal policy on AD. There were also examples cited of economies who had
increased unemployment and decreased inflation levels at the time.
Today, the mainstream view is that AD should be stimulated through monetary policy. Fiscal
policy is best used to deal with other objectives of the government ­ e.g. correcting market
failure/inequality, because of the limitations of FP in influencing AD.
Demand management
FP can be used to manipulate the level of AD ­ known as demand management.

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A larger budget deficit or a smaller budget surplus will increase injections in the economy
through the circular flow. A budget deficit occurs when government expenditure exceeds tax
revenue, which therefore increases GDP because injections become greater than
withdrawals. This is as long as its expansionary effect is not negated by savings and imports
(other withdrawals). This will be further increased through the multiplier process, according to
Keynes.…read more

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When people's money income rises, dragging them into higher tax brackets. Fiscal drag is
therefore referring to the effect inflation has on average tax rates. If tax allowances are not
increased in line with inflation, and people's incomes increase with inflation then they will be
moved up into higher tax bands and so their tax bill will go up. However, they are actually
worse off because inflation has cancelled out their pay rise and their tax bill is higher.…read more

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If the government increases their expenditure, they will need to increase taxation. As
consumers and investors pay more tax, they have less money to consume or invest,
illustrated by the Laffer curve.
Distorts signals in the labour market as a resource allocator (increased taxes reduce
disposable income, and cause a `brain drain' as individuals leave the country):
Economic agents are attracted into different markets due to higher returns (e.g.
wages). Tax placed on wages distorts their true monetary value in the marketplace.…read more

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Keynes argued to move from B to C, this would not require a 140bn stimulus because
of the multiplier effect and the accelerator theory.
4. In the multiplier theory, for every pound that is invested into the system, a greater
amount than a pound would be yield in the economy.
5. The accelerator theory states that whereas consumption is determined by national
income, investment is determined by changes in the national income.…read more

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If the government announces 500m in civil servant salaries and a 500m increase in
road building, and the multiplier is 2, this should lead to 2bn increase in output in the
Keynes model. However, it will take years to work through. The increase in civil
servant wages may be quick the road programme may take several years to start.…read more

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An increase in the national debt ­ keeps expanding as debt is added up
Financing the debt ­ the financing will incur interest, creating a leakage.
Possible benefits of a budget deficit
Can increase AD through demandmanagement policies
Stimulus to grow ­ longterm growth through infrastructure, education, which shifts
LRAS.…read more



This is a 7 page well written summary covering Fiscal policy up to A2 standard. Students should use it to enhance their own notes, create a mind map or just read and learn if they need to.

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