3.6 Fiscal Policy

Two forms of discretionary demand-side policies are:

Fiscal policy

Monetary policy

- Active government policy to influence AD is called discretionary policy

Fiscal policy

This is the manipulation of spending and taxes by the government.

Dealing with AD (C+I+G+(X-M))

Can also shift LRAS if it is not immediate effects

Affect on consumers

- Changes in direct taxes

- Income taxes, impacts disposables income) =, therefore, impacts consumer spending

However, changes in income tax may not increase AD because it depends on the government

Affect on Investment spending

Changes in business (corporation) tax = impact investment spending

Affect on Government spending

Changes in government spending directly impact AD → The government's spending will only count towards the RGDP if it is spent (spending on final goods and services in the economy)

Three potential outcomes of a government budget:

A balanced budget (revenue = expenditure)

A budget surplus (revenue > expenditure)

A budget deficit (revenue < expenditure)

Determined by the size of government revenues mainly through tax revenue versus government expenditure

Sources of revenue:

1. Indirect taxes (taxes on goods and services - VAT, sales tax)

2.Direct taxes ( taxes on income - business tax, income tax)

3.Income from state-owned enterprises

4.Income from the sale of government assets (privatisation of government industry)

Types of expenditure:

1.merit goods (Education and health care)

2.Infrastructure (Roads, bridges, government buildings, schools, airports)

3.Public goods (Non-rivalrous and non-excludable e.g. parks, military, police)

4.Transfer payments (unemployment benefits, family allowance, pension) → not towards the GDP

5.Subsidies → not towards the GDP as there is no spending on final goods and services

Which forms of expenditure do not count towards GDP?

- Transfer payments and subsidies

as the money is given to other groups in society. In order for it to count businesses have to spend the money. It will then count as C or I but not G.

What expenditure counts

Any spending by the government on FINAL goods and services on the economy counts as government spending for RGDP

- Eg. spending on resources for government agencies, building infrastructure, developing health clinics etc.

A public debt

A public debt or government debt is the accumulation of deficit minus surpluses over a period of time.

If a government runs a surplus then the government debt will decrease likewise a government that runs a deficit will increase the government debt

Types of fiscal policy:

Expansionary fiscal policy and contractionary fiscal policy

Expansionary fiscal policy (graph, example and explain)

- Implemented a deflationary gap to increase output

-Indirect: Decrease indirect taxes leading to an increase in consumer spending (income tax) and/or investment spending (business tax)

-Direct: Increase in government spending

- can increase LRAS (gov or investment spending) that increases the quality or quantity of the FOP (for example training or infrastructure spending)

- Mention both Long-term and short-term if necessary

- Short-term only changes the AD

eg. The Trump administration used expansionary policy with the Tax Cuts and Jobs act and also increased discretionary spending → especially for defense

Obama administration: Economic Stimulus Act.9 The American Recovery and Reinvestment Act cut taxes, extended unemployment benefits and funded public works projects. 10 The law which was enacted in 2009, was meant to stimulate the weakening economy, costing $787 billion in tax cuts and government spending. 11 All of this occurred while tax receipts dropped thanks to the 2008 financial crisis

Contractionary Fiscal Policy (graph, example and explain)

Decrease in AD: Increase in direct taxes or a decrease in govenrment spending to decrease aggregate demand.

Aim: Close an inflationary gap

- Does not happen often because people do not want to pay more taxes so the government risks losing the next election

- Increase taxes: firms and households will have less wealth, decreasing consumption and investment

- Decrease government spending (main policy)

eg. Bill Clinton used contractionary fiscal policy by cutting spending in several key areas. First, he required welfare recipients to work within two years of getting benefits. After 5 years, benefits were cut off. He also raised the top income tax rate from 31% to 39.6%

Autonomous vs Induced expenditure (graph)

Induced: results of an increase in national income

- leakages

- movement up or down along expenditure curve

- national income increases, consumption increases = induced form of expenditure

- more income you make = more expenditure

Autonomous: does not originate from an increase in GDP but is driven by other factors

expenditure when income = 0 (horizontal line)

eg. when the government borrows, use foreign reserves as forms of assets

- injections (exports, investment, gov spending)

- influenced by interest rates, business confidence, policies etc.

- upward or downward shift of expenditure curve (higher or lower at any given level of national income)

State Keynesian Multiplier formula (K)

- find the change in GDP as a result of a government fiscal policy.

- shows that any increase in the value of injections into the circular flow of an economy = larger increase in AD

- change in injections that directly inmpacts national income

- leads to change in consumption = household adjusts their spending to their new level of income

- leads to further changes in national income

- a cycle -> income change leads to further conumption

- negative multiplier effect = initial leakage leads to greater proportion in final RGDP

Injections:

- stimulate more spending (increases spending from individuals)

Leakages:

- withdrawls = lower value of multiplier (Savings, taxes, imports)

Keynesian multiplier = 1/1-MPC = 1/MPS+MPT+MPM

k = final change in Y / initial change in injections

- more saving = lower multiplier

positive or negative keynesian

Reverse keynesian multiplier

- increase in injections = more proportional rise in RGDP = boost economic activity

- decrease in injections = decline in RGDP = contract economic activity

Key parts of keynsian multiplier

MPC

MPS

MPT

MPM

MPW

Marginal Propensity to consume (MPC)

Marginal proportion to save (MPS)

Mariginal proportion to withdraw (MPW)

MPC: proportion of an increase in household income that is spend on goods + services rather than saved

- MPC = Change in C (consumption)/ Change in Y (Income)

- greater MPC = greater multiplier effect (eg. reduction in income tax = more disposable income)

- higher = stronger multiplier effect

MPS: proportion of an increase in household income that is saved not spent

- MPS = change in S/change in Y

- more people save their income = decrease in multiplier (leakage)

MPW: MPT + MPS + MPM or 1 - MPC

- higher MPW = weaker multiplier effect

- higher = more income leakages (saving, taxes or imports) = weaker impact on RGDP

Maringal propensity to import (MPM)

Marginal propensity to tax (MPT):

MPM: proportion of an increase in household income spent on imports (not dom.)

- MPM = change in M/ change in Y (income)

- larger leakage = lower the value of keynesian (spend larger proportion of income on imports = fall in multiplier (reduce gov attempt to boost spending)

MPT: proportion of each extra dollar of income earned that is taxed by the government

- dependent on marginal rate of tax paid by houseold

- MPT = change in T/ change in Y

- higher MPT = lower multiplier

Effectiveness of fiscal policy (constraints)

-Time Lags/everything takes time

- Political constraints

- Sustainable budget

- Effectiveness in a recession:

- Unable to deal with cost-push inflation (supply-side)

- crowding out

Time Lags/everything takes time:

To recognize the problem

To decide how to deal with it

To pass the necessary legislation

For it to have an effect on the economy

- It takes time to implement fiscal policies. Bureaucracy takes time, and the injection of money will take time.

Political constraints

Difficult to implement major spending programs as the government has to pass it

- It is difficult to change tax codes. Governments have to agree to change and pass the legislation

eg.with COVID-19, the US had to authorize more than $2 trillion in assistance → three stimulus checks: $1,200 for every qualifying adult and $500 for every child in April 2020, $600 for every qualifying adult and dependent child in December 2020, and with the passage of the American Rescue Plan Act in March 2021, a third check of $1,400 for qualifying adults and each for their dependents.

Effectiveness in a recession:

Tax cuts are less effective in a recession than increases in government spending because part of the increase in after-tax income is saved.

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

- If the proportion of income saved rises due to pessimism about the future, the impacts of tax cuts on AD are even weaker

- Increases in government spending are more powerful because they work in their entirety to increase AD

Sustainable budget

Borrowing may be needed to finance govenrment spending. This will need to be services (interest and payments will be made) and eventually paid back.

This could lead to austerity (budget balancing) measures in the future which could impact the economy then.

Unable to deal with cost-push inflation (supply-side)

- Inflation requires a contractionary policy, recession required an expansionary policy.

- instability by supply-side factor = cost-push

falling real GDP + inflation simultaneously, fiscal policy is unable to deal with it effectively.

- contractionary policy could address the problem but would make the recession worse;

- expansionary policy could help get the economy out of recession but would worsen inflation

Crowding out (graph and def)

- increased government spending ultimately decreases private sector spending

- expansionary fiscal policy = government reduce private sector spending/investments

- government borrowing = competition with others in the economy who want to borrow the limited amount of savings available = real interest rate rises + private investment falls (crowd out)

Strengths of Fiscal Policy

-Government spending in a deep recession

- Targeting of specific sectors

- Fiscal policy and the effect on growth

- Fiscal policy and the effects on potential output

- stable and low inflation

- Fiscal policies can include Automatic Stabilizers (HL):

Government spending in a deep recession

Classical economists believe the economy will self correct and return to the full employment level of output

The 1930s showed this does not always happen and the economy can be stuck in a recessionary gap

Keynes proposed government spending which proved effective in pulling the economy out of the Great Depression

Targeting of specific sectors

Governments can target spending on the areas most in need in the economy

This could be targeted to specific groups, geographic regions or sectors of the economy

Fiscal policy and the effect on growth

Direct impact through government spending on infrastructure

Indirectly influence AD through taxes which can encourage business investment = and lead to long-term growth

Long-term indirect impact as economic stability leads to long-term business planning and investment = reduces major fluctuations and encourages activities that create growth

Fiscal policy and the effects on potential output

Spending on physical/human capital = increase in quantity or quality of factors of production = potential output

Fiscal policy and low and stable inflation

help close an inflationary gap and lowering inflation through contractionary policy

- reduce aggregate demand by decreasing government spending and consumption/investments (due to higher taxes)

- decrease in AD (shift left) = moving towards lower inflation rate and closing inflationary gap

Fiscal policies can include Automatic Stabilizers (HL):

Fiscal policies that naturally reduce fluctuations of the business cycle.

Progressive taxes: A tax system where people with higher income have a higher tax rate.

- people suddenly earn less in a recession, tax rates automatically decease as people go into lower tax brackets.

- higher income = higher tax which reduces disposable income (moderate AD)

Unemployment benefits: a transfer payments for the unemployed (ensure they have enough money for necessities)

- given to every unemployed person = automatically adjust when more people lose their jobs.

- maintain a level of consumption + less decline in AD

- economic boom: fewer people claim benefits, reducing gov. spending

eg. During the COVID, countries with strong social safety nets, (Germany) used unemployment benefits to support household incomes, which helped cushion the decline in AD.