Fiscal Policy

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3.2:4 Macroeconomic Policy Fiscal Policy
Specification Candidates should understand fiscal policy can have both macro and
microeconomic functions. They should be able to explain how it could be used to influence
aggregate demand and aggregate supply, and also how government spending and taxation
can affect the pattern of economic activity.
So this sheet covers:
1. The function of fiscal policy.
2. How fiscal policy affects aggregate demand and aggregate supply.
3. How government spending and taxation affect the pattern of economic activity
Fiscal Policy Decisions to manipulate government spending, borrowing and taxation.
What is Fiscal Policy?
For the last 20 years the government have been responsible for between 40% and 50% of
national expenditure mainly on the NHS, defence, education and infrastructure
(predominantly roads). They also transfer large amounts around the economy in the form of
social security and National Insurance benefits. All of this is mainly financed through taxes
e.g. VAT and income tax.
Balancing the Budget
In most years they have run Budget Deficits , spending more than they receive. As a result,
in most years the government borrows money. In the UK borrowing of the public sector
(central / local government and other state bodies) over a period of time is called the Public
Sector Net Cash Requirement . In three fiscal periods (between 19691970, 19881991 and
19992001) the government received more than it spent the usual budget deficit was a
Budget Surplus there is then a negative PSNCR. A budget surplus allows the government
to pay off some of its accumulated debt. This debt, called the National Debt, dates back to
the founding of the Bank of England in 1694. The government has to make decisions about
how much to spend, tax and borrow and the composition of these, for example, should it cut
income tax by raising excise duties? Should it spend more on education and less on defence?
These decisions about spending, taxes and borrowing are called the Fiscal Policy of the

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Fiscal Policy and Aggregate Demand
Government spending and taxation changes
have an effect on aggregate demand. A rise
in government spending, with the price level
constant, will increase aggregate demand,
pushing the AD curve to the right as in figure
2. Equally, a cut in taxes will affect
aggregate demand. A cut in taxes on
income, such as income tax and National
Insurance contribution, will lead to a rise in
the disposable income of households.…read more

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The Multiplier
The multiplier is a rise in government spending (G) will not just increase aggregate demand
by the value of the increase in G. There will be a multiple increase in aggregate demand. This
multiplier effect will be larger the smaller the leakages from the circular flow. In a modern
economy, where leakages from savings, taxes and imports are a relatively high proportion of
national income, multiplier values tend to be small.…read more

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The fiscal policy transmission mechanism
This flowchart identifies some of the channels involved with the fiscal policy transmission
mechanism ­ in the example shown we focus on an expansionary fiscal policy designed to
boost demand and output
The multiplier effects of an expansionary fiscal policy depend on how much spare
productive capacity the economy has how much of any increase in disposable income is
spent rather than saved or spent on imports.…read more

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However when it is used to influence directly the level of aggregate demand, it becomes an
example of the Demand Side Policy or Demand Management.
Inflation an increase in government spending or a fall in taxes which leads to a higher
budget deficit or lower budget surplus will have a tendency to be inflationary.A higher budget
or lower budget surplus leads to an increase in aggregate demand.…read more

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By providing goods and services directly, the government influences the level of provision ig
the goods, such as public and merit goods. If left to the market forces, these goods would
either be under provided, or not provided at all.
Through public spending and taxes, the government influences the pattern of economic
activity in the private sector. Such as taxes on cigarettes (or other demerit goods) discourage
their consumption.…read more

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Aggregate Demand
Contractionary Fiscal
Policy…read more


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