3.6: Fiscal Policy

Sources of government revenue.

- Direct taxes.

- Indirect taxes.

- Sale of goods/services.

- Sale of government-owned enterprises.

Types of government expenditure.

- Current expenditure.

- Capital expenditure.

- Transfer payments.

Current expenditure.

Government spending on the day-to-day items.

Examples of current expenditure.

- Wages/salaries for government workers.

- Supplies/equipment for government activities.

- Subsidises.

- Interest payments on government loans.

Public/government debt

Government's accumulation of deficits minus surpluses over time.

Government budget

Plan of country's tax revenues and expenditures over a time period.

Balanced budget

Expenditures = revenues.

Budget surplus

Expenditures < revenues.

Budget deficit

Expenditures > revenues.

Fiscal policy

Manipulations by the government of its own expenditures and taxes in order to influence the level of aggregate demand.

What components of aggregate demand does fiscal policy influence?

Consumer spending (C), Investment spending (I) and Government spending (G).

Goals of fiscal policy.

- Low and stable inflation.

- Low unemployment.

- Reduce business cycle fluctuations.

- Promote a stable economic environment for long-term growth.

- External balance.

- Equitable distribution of income.

When is expansionary fiscal policy used?

During a recessionary gap; insufficient aggregate demand; real GDP < potential GDP.

What does expansionary fiscal policy do?

- Increase aggregate demand.

- Shifts AD to the right.

- Increases real GDP.

How is expansionary fiscal policy carried out?

- Increasing government spending.

- Decreasing personal income and business taxes.

When is contractionary fiscal policy used?

During an inflationary gap; excess aggregate demand; real GDP > potential GDP.

What does contractionary fiscal policy do?

- Decreases aggregate demand.

- Shifts AD to the left.

- Decreases real GDP.

How is contractionary fiscal policy carried out?

- Decreasing government spending.

- Increase personal income and business taxes.

Keynesian ratchet effect

If AD decreases, price level does not decrease.

How does fiscal policy DIRECTLY affect potential output?

- Improves quality of capital goods.

- Improves quality of labour force.

- Labour becomes more productive.

- Increases quantity of capital goods.

- Contributes to R&D; technological innovations.

How does fiscal policy INDIRECTLY affect potential output?

- Creates an economic environment favourable for private investment.

- Reduces fluctuations of the business cycle.

Strengths of fiscal policy.

- Pulling an economy out of a deep recession.

- Ability to target sectors of the economy.

- Direct impact of government spending on AD.

- Dealing with rapid and escalating inflation.

- Ability to affect potential output.

- Automatic stabilisers.

Automatic stabilisers

Factors that automatically stabilise economy; no government action.

Examples of automatic stabilisers

Progressive income taxes and unemployment benefits.

Constraints of fiscal policy.

- Time lags.

- Political constraints.

- Sustainable debt.

- Tax cuts may not be effective in increasing AD.

- Inability to 'fine tune' economy (no precise target).

- May be inflationary.

- Inability to deal with with stagflation.

- Crowding out.

What is crowding out?

- Governments increase borrowing.

- Increased demand for money, increased interest rate.

- Less investment spending (crowding out).

- Counteraction to expansionary fiscal policy.

Partial crowding out.

Increase in government spending > decrease in investment spending.

Complete crowding out.

Increase in government spending ] decrease in investment spending.

Initial increase in expenditure is less than...

increase in real GDP.

Keynesian Multiplier

Change in real GDP ÷ initial change in expenditure.

If multiplier > 1,

Change in real GDP > initial change in expenditure.

Example of induced spending

Increase in investment spending.

- Owners of FOPs receive income.

- Increases consumption spending.

- AD and real GDP increase more.

- This repeats.

Marginal Propensity to Consume (MPC)

Fraction of additional income that households spend on the consumption of domestically produced goods/services.

- Rest flows out of income model.

Leaks

- Marginal Propensity to save (MPS).

- Marginal Propensity to tax (MPT).

- Marginal Propensity to import (MPM).

Marginal Propensity to save (MPS)

Fraction of additional income saved.

Marginal Propensity to tax (MPT)

Fraction of additional income taxed.

Marginal Propensity to tax (MPM)

Fraction of additional income spent on imports.

MPC + MPS + MPT + MPM =

1

Keynesian Multiplier is also =

1 ÷ (1-MPC) and 1 ÷ (MPS + MPT + MPM)

Larger MPC means...

More income spent, less leakages, greater multiplier.

Autonomous spending

Initial increase in expenditure/change in real GDP.

- Not caused by a change in income.

Induced spending

Induced change in consumption expenditure.

Effects of aggregate demand =

Autonomous + induced

Effects of aggregate demand also =

Autonomous + (autonomous x multiplier)

What causes aggregate demand to increase and the multiplier effect to occur?

Any factor that increases AD and spending.

Multiplier effect initiated by...

a change in spending.

The multiplier has the greatest effect when...

The price level is constant.