Fiscal policy

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Types of Fiscal Policy

Fiscal policy is used to achieve government objectives using taxation, public spending and the budget deficit/surplus:

  • Keynesian fiscal policy - demand-side fiscal policy uses increases in govt. spending and decrease in taxation to boost AD. Increase in govt. spending is an injection into the circular flow of income
  • Discretionary fiscal policy - When fiscal policy is used to raise/lower taxes and government spending in otder to manage AD and maintain a high level of employment and avoid an increase in the rate of inflation
  • Supply side fiscal policy - Tax cuts to increase incentives to work harder and increase LRAS through risk-taking and investment
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Effects of expansionary fiscal policy

  • Increase in government spending/decrease in taxation is an injection into the circular flow of income, this causes AD to increase
  • Eliminates cyclical demand if the economy is in recession or negative output gap
  • Could cause demand pull inflation depending on how close the economy is operating to YFE
  • Inflationary if close to YFE and AD increases, reflationary if far from YFE and AD increases
  • Expansionary fiscal policy effects are short-lived and main effect is inflation
  • Government spending multiplier - e.g. if increase in govt. spending is £10bn, the resulting increase in nominal national income is £40bn if the size of the multiplier is 4. 
  • Most real output is produced by the private sector
  • Could result in crowding out - when government spending grows at the expense of private sector spending but there is no overall increase in output.
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Effects of taxation

  • Reduces the amount of income that people have available to spend on consumption/imports (disposable income)
  • Alters the relative price of goods and services
  • Finances government spending
  • Progressive taxation helps distribution of wealth and income by taxing the rich and distributing to the poor through welfare benefits 
  • Supply siders argue that taxation reduces incentives to work and be entrepreneurial and increases incentives to live off benefits. (Laffer curve?) 
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Recent fiscal policy

  • Main areas of UK govt spending in 2013 were: welfare and pensions (social ‘protection’), health, education, public order and safety, and defence.
  • The new coalition government after the recession, dominated by the conservatives, favoured a return to supply side fiscal policy. 
  • Taxes were raised and govt. spending was severely cut, and fiscal austerity replaced the fiscal stimulus. 
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