2.4 Fiscal Policy

Construct a diagram to show the potential effects of contractionary fiscal policy, outlining the importance of the shape of the aggregate supply curve

(search image: importance of LRAS shape for expansionary fiscal policy) A decrease of AD in the horizontal part (not at full employment) of the AS curve, makes the fall in real GDP larger, and the drop in the price level smaller. If the AD decrease occurs in the vertical part of the AS curve (when the economy is at full employment), the fall in real GDP will be smaller/non-existent, whereas the drop in price level will be larger.

Construct a diagram to show the potential effects of expansionary fiscal policy, outlining the importance of the shape of the aggregate supply curve

(search image: importance of LRAS shape for expansionary fiscal policy) Assuming that the economy was in equilibrium at Y1, the increasein AD from AD1 to AD2 leads to an increase in real output without the average price level being adversely affected. If however, the deflationary gap was smaller and the economy was in equilibrium at Y3, then the increase from AD3 to AD4 would lead not only to an increasein real output but also to some increase in prices (reasonable for some inflation). If the economy is at full employment and government expenditures increase an/or taxes decrease, the resulting increase in AD will prove only inflationary.

Types of government expenditures (spending):

- Current expenditures - spending on items used up in providing a good or service - wages, salaries and expenditure on consumable items such as stationery, books for school, etc. - Capital expenditures - spending on assets, items which last and can be used again and again to provide a good or service - the construction of a school, bridges, etc. These are additions to the capital stock. - Transfer payments - payment of money from a government to its citizens for which there is no corresponding increase in output - social security, unemployment benefits.

Define Fiscal Stance

The expected and desired impact on the future economy due to taxation and government spending.

Evaluate the effectiveness of fiscal policy through consideration of factors including the ability to target sectors of the economy, the direct impact on aggregate demand, the effectiveness of promoting economic activity in a recession, time lags, political constraints, crowding out, and the inability to deal with supply-side causes of instability

Advantages: - it is direct --> any increase in government spending will automatically increase national income by at least as much, as it is a component of AD - a decrease in taxes to reflate an economy as part of an expansionary stimulus plan may also have beneficial supply-side effects as lower taxes may improve the incentives to work and to invest - when interest rates are at or close to zero when an economy is in deep recession, fiscal policy is the only effective policy - if the economy is equipped with unemplyment benefits and a progressive income tax system, then policy makers have the benefits of built in stabilizers - if the increased gov. expenditures including spending on infrastructure, health and education then a positive supply-side effect will also result - if the increased gov. expenditures including spending on the development of green technologies then an additional long-run benefit will be the improvement of the environment, allowing sustainable growth Disadvantages: - there are significant time lags associated with fiscal policy that may end up destabilizing instead of stabilizing an economy *detection lag = it takes time to collect and evaluate data in order to detect a problem *administrative lag = it takes time for the gov to decide how much it needs to spend and on exactly what projects * the execution or impact lag = it takes time for whatever policy response was chosen to have effects on the exonomy, esp. since the cumulative impact of the multiplier is long - large deficit spending may increase national debt to unsustainable levels, forcing significant tax increases in the future - inflationary pressures may arise as a result of the expansionary fiscal effect continues longer than required - expansionary fiscal policy and deficit spending may end up crowding out private investment and therefore be less effective, the resulting budget deficit must be financed, government borrowing may increase interest rates and as a result private investment will decrease (in addition to consumption expenditures) - fiscal policy suffers from expansionary bias because politicans are often irresponsible and prefer to spend more and tax less rather than spending less and tayinf more because the former maximizes their short term re-election chances - expansionary fiscal policy may also lead to a widening trade deficit, a higher income will lead to more imports absorbed, if the average price level increases then exports will shrink as they become less competetive and imports will rise as they become more attractive than domestic products - contractionary fiscal policy to fight inflationary pressures is often difficult to employ, societies usually do not welcome decreases in spending relation to social welfare or in education and helth or defence programmes, increasing taxation beyond a point will adversely affect incentives in the economy - an increase in gov expenditures as part of an expansionary fiscal policy cannot be easily reversed if policy makers realize that it leads to overheating

Distinguish between a budget deficit, a budget surplus and a balanced budget

Budget deficit - government spending exceeds government income. Budget surplus - government income exceeds government spending. Balanced budget - government spending equals government income.

Explain crowding out using a diagram

Crowding out occurs when government spending fails to increase overall AD because higher government spending causes an equivalent fall in private sector spending and investment. Impact of higher government spending on aggregate demand: 1. increasing tax - if the government increases tax on the private sector (i.e. higher income tax, higher corporation tax), then this will reduce the income of consumers and firms. Ceteris paribus, increasing tax on consumers will lead to lower consumer spending. Higher government spending financed by higher tax should not increase overall AD because the rise in G is offset by the fall in C. 2. Increasing borrowing - if the government increases borrowing, it borrows from the private sector. To finance borrowing, the government sell bonds to the private sector (i.e. private individuals, pension funds or investment trusts). If the private sector buy these government securities they will not be able to use this money to fund private sector investment. Therefore, government borrowing crowds out private sector investment. It depends on the state of the economy whether or not crowding out occurs. There is a given amount of savings in the economy and this is represented by the supply of loanable funds curve. The price of these loanable funds is the interest rate. The increased demand from D1 to D2. for savings in order to finance a deficit results in an increase in the interest rate from i1 to i2. The higher interest rate may reduce the incentive for businesses to invest, so it is possible that invesment will fall from I1 to I2. Keynesian economists argue that crowding out will not occur if the economy is producing at less than full employment. The new classical economists argue that crowding out is a significant problem of increased government spending.

How does the government earn revenue?

Direct (taxes on the income of individuals - income tax, and taxes on companies' profits - corporation tax) and indirect taxes. Sale of goods and services provided by a government, eg, fees are paid to access some parks and museums and government buildings or land is rented out. Sale of state owned (government owned) enterprises.

Explain how changes in the level of government expenditure and/or taxes can influence the level of aggregate demand in an economy

Expansionary fiscal policy - government spending is increased and/or taxes are reduced to increase the level of aggregate demand in an economy. - If government spending is increased, for example, on an investment project such as new roads, this will increase the government spending component of AD. (Note, this can also shift the LRAS curve to the right). - If income taxes are reduced, the consumption component of AD will increase as people will have more disposable income. - If corporation tax is reduced, the investment component of AD will increase as firms have more available funds to invest. Contractionary fiscal policy - government spending is decreased and/or taxes are increased to decrease the level of aggregate demand in an economy.

Describe the mechanism through which expansionary fiscal policy can help an economy close a deflationary (recessionary) gap

Expansionary fiscal policy aims at increasing AD in order to increase national income (real output) and employment to close a deflationary gap. It requires an increase in government spending and/or a decrease in taxation. Government spending is a component of AD, therefore cuasing a rise in G to directly increase AD, shifting it to the right. In other words, if private spending (C+I) is not sufficient to generate full employment, then a government should increase its spending by borrowing from the private sector. A decrease in taxation will also increase AD as it will increase the disposable income that people have and will induce more spending.

Define fiscal policy

Fiscal policy refers to changes in government spending and/or taxes to influence the level of aggregate demand in an economy = a demand side policy. (Keynesian economists advocate the use of fiscal policy)

Explain that fiscal policy can be used to promote long-term economic growth (increases in potential output) indirectly and directly

It is possible to use fiscal policy to promote long-term economic growth (a shift of the LRAS and AD curve to the right). This can be achieved DIRECTLY through government spending on capital goods and human capital (spending on education and training to raise the skills of workers) as well as provision of incentives for firms to invest. This can also be achieved INDIRECTLY by creating an economic environment that is favourable to private investment, and by creating incentives for firms to invest (i.e. tax benefits). To encourage greater investment, the government can lower corporate taxes so that firms enjoy higher after-tax profits that can be used for investment.

Describe the mechanism through which contractionary fiscal policy can help an economy close an inflationary gap

The contractionary fiscal policy helps an economy to close an inflationary gap as the government decreases government expenditures and increases taxes so that AD decreases. The decrease in government expenditures (G) will directly decrease AD (or slow down its increase) while an increase in direct taxes will decrease disposable incomes, lowering consumption, and thus AD. AD shifts left to alleviat inflationary pressures (a decrease in the average price level), but also risking a contraction of the economy (lower level of output and a higher rate of unemployment). The risk of contraction depends on the shape of the AS curve.

Explain how factors including the progressive tax system and unemployment benefits, which are influenced by the level of economic activity and national income, automatically help stabilize short-term fluctuations

The event of an external shock which causes short-term fluctuations in output can be self stabilized by automatic stabilizers. These refer to economic policies and programs designed to offset fluctuations in a nation's economic activity without intervention by the government or policymakers. They influence the rate of GDP and counter swings in teh business cycle. During phases of high economic growth automatic stabilizers will help to reduce the growth rate and avoid the risks of an unsustainable boom and accelerating inflation - (With higher growth, the government will receive more tax revenues, since people earn more and so pay extra income tax. With higher growth, there will also be a fall in unemployment so the government will spend less on unemployment and other welfare benefits). Progressive tax system: a system of taxation in which persons or corporations are assessed at a greater percentage of their income according to the theoretical ability to pay. Taxpayers pay more in taxes if they earn more in income. Thus, as people's incomes rise, they will fall into higher tax brackets and wil pay higher rate of tax. In a recession, economic growth becomes negative but automatic stabilizers will help to limit the fall in growth. With lower incomes people pay less tax, and government spending on unemployment benefits will increase. The result is an automatic increase in government borrowing with the state sector injecting extra demand into the circular flow of income. THUS: automatic stabilizers help to provide a cushion of demand in an economy and support output during a recession.

Explain the relationship between budget deficits/surpluses and the public (government) debt

The national debt is an accumulation of previous budget deficits - money has been borrowed to finance the deficits. National debt is all government debt outstanding. Budget deficits add to the national debt. Budget surpluses can be used to pay off part of the national debt, and if this is done, the national debt is reduced.