IB Economics Fiscal Policy

Fiscal Policy Definition

Refers to the manipulation by the government of its own expenditures and taxes

Sources of government revenue

Taxes of all types (business and personal income)

Government expenditure (sale of goods and services like transportation and water) (selling enterprises and property = privatisation)

Types of government expenditures

Current expenditure = G

Capital expenditure = G

Transfer payments

Current expenditure

day to day items and items used when a good or service is provided like wages for gov. employees, subsidies, medication, interest on gov. loans

Capital expenditure

public investments or production of physical capital (buildings, roads, airports)

Transfer payments

payment by the government to vulnerable goods, redistribution of income

Affecting three components

Government

Consumption

Investment

Expansionary fiscal policy done by and their effects

Increasing government spending

Decreasing personal income taxes - more disposable income

Decreasing business taxes - more investment

A combination of increasing spending and decreasing taxes

Expansionary fiscal policy

used for

eliminating recessionary gap

Expansionary fiscal policy diagrams M + K

price levels increase in M more than in K

DO on paper

Contractionary fiscal policy

Decreasing government spending

Increasing personal income taxes

Increasing business taxes

A combination of decreasing spending and increasing taxes

Contractionary fiscal policy used for

eliminating inflationary gap

Contractionary fiscal policy diagrams

Do on paper

Fiscal policy and long term economic growth

Indirect effects on potential output (encouraging activity like planning and investment)

Direct effects on potential output

Allocate a portion of government spending to the development of physical capital = infrastructure , human capital = education

Fiscal Policy Strengths

Pulling economy out of deep recession

Dealing with rapid and escalating inflation

Ability to target sectors of the economy

Direct impact of government spending on aggregate demand

Ability to affect potential output

Fiscal Policy Weakness

Time lags

Political constraints

Crowding out → G = government spending , I = investment spending (goes foward but I makes it go back)

Inability to deal with supply-side causes of instability

In a recession, tax cuts may not be very effective in increasing AD

Inability to "fine tune" the economy

Automatic Stabilisers

Factors that automatically work towards stabilising the economy by reducing the short-term fluctuations of the business cycle. They are

Progressive income tax and Unemployment benefits.

Progressive income tax in inflation

When rGPD and income increase, gov revenue also increase because more taxes are paid. So there is less disposable income shifting AD to the left contraction economic expansion

Progressive income tax in recession

more disposable income allows increase in AD while rGDP+income+gov rev decreases

Unemployment benefits in recession

increase in recession without AD decreasing

Unemployment benefits in inflation

decrease allowing consumption to increase slower

Unemployment benefits

reduce the severity of economic fluctuations

Progressive income tax

the more progressive an income tax system is the greater the stabilising effect on economic activity

Multiplier and fiscal policy

The larger MPC the large the multiplier so the larger the income

Fiscal policy and long term economic growth overall

allows for an increasing stable macroeconomic environment and leads to an increase in AD which grows GDP