3.11. government budget, demand side policies -> fiscal policy

government budget

type of plan of a country’s revenues and expenditures over a period of time

sources of government revenue

• taxes of all types

• sale of goods and services

• sale of government-owned assets or property

types of government expenditures

• current expenditures

  • day to day items (wages, salaries, supplies, equipment, subsidies and interest)

• capital expenditures

  • public investment, spending to produce physical capital

• transfer payments

  • payments by the government to vulnerable groups

fiscal policy

government manipulation of its own expenditures and taxes to influence the level of AD

goals od fiscal policy

• low and stable rate of inflation

  • fiscal policy doesn’t have any inflation target but may be used to complement monetary policy if it is not as effective as expected

• low unemployment

  • improving cyclical unemployment

• reduce business cycle fluctuations

• promote a stable economic environment for long term growth

• equitable distribution of income

role of fiscal policy in demand management

fiscal policy can affect

• level of government spending

• level of consumption spending

• level of investment spending

expansionary fiscal policy

• to expand AD

  • expanding economic activity

• closing a recessionary gap

• to achieve full employment or potential output

expansionary fiscal policies types

• increased government spending

• decreasing personal income taxes

  • rise in disposable income → increased consumption spending

• decreasing business taxes

  • rise in after-tax profits → increased investment spending

• combination of the 3 above

contractionary fiscal policy

• to contract AD

  • contracting economic activity

• closing an inflationary gap

• to achieve full employment or potential output

contractionary fiscal policies types

• decreased government spending

  • left shift AD

• increased personal income taxes

  • after tax income falls

  • consumption spending falls

• increased business taxes

  • after tax income falls

  • investment spending falls

• combination of the 3 above

differences monetary vs fiscal: to fix deflation

monetary policy:

• increase supply of money/ lower interest rate

  • increase consumption spending

  • increase investment spending

fiscal policy:

• increase government spending

• lower personal income taxes

  • increase consumption spending

• lower business taxes

  • increase investment spending

differences monetary vs fiscal; to fix inflation

monetary policy:

• decrease supply of money/ raise interest rate

  • decreased consumption spending

  • decreased investment spending

fiscal policy:

• decrease government spending

• raise personal income taxes

  • decrease consumption spenidng

• raise business taxes

  • decrease investment spending

constrains on fiscal policy

• time lags

• political constraints

• (in recession) tax cuts may not be effective in increasing AD

• inability to set clear targets

• may be inflationary

• inability to deal with cost push inflation or stagflation

• crowding out effect

crowding out effect

when increased government spending leads to a reduction in private sector spending and investment

• expansionary fiscal policy involving increasing spending without increases in revenues

• government forced to borrow

• increase in demand for money

• increase in the rates of interest

• lower investment spending by private firms → “crowding out” private investment

partial crowding out

fall in investment spending < increase in government spending

complete crowding out

fall in investment spending = increase in government spending

strengths of fiscal policy

• pulling an economy out of 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 stabilizers

automatic stabilizers

factors that automatically, without any action by authorities, work towards stabilizing the economy

• reduces short term fluctuations of the business cycle

types of automatic stabilizers

• progressive income taxes

  • inflationary gap: rGDP and income increase, income taxes rise more than the rise in income → AD increases less

  • deflationary gap: rGDP and income decrease, income taxes fall more than income → AD decreases less

• unemployment benefits