fiscal policy


Macro vs Micro fiscal policy

Fiscal policy was generally associated with managing the level of AD in order to expand (reflate) or contract (deflate) the economy

Keynsian Fiscal policy

  • To increase demand, the government increases government spending or cuts taxes.
  • The resulting increase in the governments budget deficit injected demand into the circular flow of income - expansionary fiscal policy

Discretionary fiscal policy

  • Contractionary fiscal policy involved  the opposite: cuts in government spending or tax increases which reduced the budget deficit, possible moving the government's finanaces into surplus - takes demand out of the economy

Tax rates and levels of government spending are regularly adjusted to try and maintain a high level of employment, while avoiding unacceptable increase in the rate of inflation

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Fiscal policy continued...

  • Fiscal policy was used as part of a wider supply-side policy to increase the role of markets and the private sector's economic activity, and to reduce the economic role of the state
  • Under monetarist and supply-side influence, recent UK governments believed that using fiscal policy to stimulate or relfate AD to achieve growth and full employment is, in long run, at best ineffective and worst damaging
  • Monetarists have argued that any growth of output and employment resulting from an expansionary fiscal policy is short-lived
  • The main effect of such a policy is inflation
  • Fiscal policy has recently been used to create stability in the economy, so that economic agents, particularly businesses, are not subject to sudden surprises in the form of unexpected tax changes
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Mirco elements

Micro elements of fiscal policy:

  • Focus on the use of fiscal incentives aimed at improving economic performance on the supply side.
  • Lower rates of income tax increase incentives to save, work harder and be entrepreneurial.
  • On the public spending side of fiscal policy, changed to the benefits system have been made to alter the labour or leisure choice in favour of working rather than choosing voluntary unemployment
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Using AD/AS diagrams to analyse

Demand-side fiscal policy 

  • Operates through increasing or decreasing AD.
  • Government spending is one of the components of AD
  • An increase in government spending or a cut in taxation increases the size of the budget deficit
  • Either way, an injection into the circular flow of income occurs and the effect on AD is expansionary
  • To stop cyclical unemployment  the government increases the budget deficit by raising the level of government spending or by cutting taxes.
  • The expansionary fiscal policy shifts the AD curve to the right  
  • However this can create excess demand that leads to demand-pull inflation
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How fiscal policy affects the pattern of economic

Government spending multiplier

  • if the size of the government spending multiplier is 4, an initial increase in government spending of £10 billion increases national income by £40 billion, and most of this is produced by the private sector
  • however many free-market economists believe that the main-effect of an increase in government spending is to crowd out private sector spending
  • Tax as well as government borrowing are used to finance goverment spening
  • taxation obviously reduces the amount of income that people have available to spend on consumptopn or imports
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Progressive taxation

  • leads to the rich paying a larger proportion of their income on taxes than the poor
  • keynesian governments transfer the revenue raised frrom progressive taxation to the poor, in the form of welfare benefits
  • this alters distibution of income in favour of lower-income groups
  • as a result, pattern of production and spending change away from goods and services consumed by the better-off to those consumed by the poor
  • Free-market economists believe that progressive taxation and transfers to the poor have a bad effect on personal incentives - reducing the incentives to work and to be entrepreneurial, while increasing the incentive to live off benefits
  • the supply-side fiscal policy advocated by free-market economists attempts to reduce taxation ,government spending and the size of the state - which then frees up resources for the private sector to use

Fiscal policy also affects the pattern of economic activity through state provision of public goods and merit goods, and through the use of expenditure taxes and subsidies to alter the relative prices of goods and services

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