economics theme 2 : fiscal policy (demand side policies)

fiscal policy definition

involves the use of gov spending, taxation and borrowing to influence both the pattern of economic activity and also the level and growth of aggregate demand, output and employment

Keynesian school view on fiscal policy

argues that fiscal policy can have powerful effects on aggregate demand, output and employment when the economy is operating well below full capacity (below full employment), and where there is a need to provide a demand-stimulus to the economy

monetarist economists view of fiscal policy

believe that gov spending and tax changes can only have a temporary effect on aggregate demand, output and jobs and that monetary policy is more effective

two types of fiscal policy

expansionary and contractionary

explanation of expansionary fiscal policy

• cut in personal income tax → boost to disposable income → adds to consumption

• cut in indirect taxes → lower prices - leads to higher discretionary incomes → adds to consumption

• cut in corporation tax → higher ‘post tax’ profits for businesses → adds to business capital spending

• cut in tax on interest from saving → boost to disposable income of those with net savings → adds to consumption

explanation of contractionary fiscal policy

• increase in personal income tax → decrease in disposable income → fall in consumption

• increase in indirect taxes → higher prices - leads to lower discretionary incomes → fall in consumption

• increase in corporation tax → lower ‘post tax’ profits for businesses → lower business capital spending

• increase in tax on interest from saving → decrease in disposable income of those with net savings → fall in consumption

criticisms of fiscal policy

• crowding out

• time lags

• position of the AD curve on the Keynesian model

• shape of the LRAS

crowding out explanation

if the government borrows from the private sector, there are fewer funds available for the private sector, which could lead to crowding out

time lags explanation

identification lags : how quickly can you identify / find out if you need to contract or expand AD, forecasting can also be inaccurate, identifying problems takes time

implementation lags : which tax / area of gov spending is going to be the most effective at changing this?

impact lags : once you’ve announced it, how long does it take for the tax / gov spending to take effect?

position of AD curve explanation

• if there’s spare capacity then an expansions fiscal policy will cause an increase to economic growth, leading to higher output without an increase to inflation

• if there is no spare capacity then there is no point increasing fiscal policy as this would lead to inflation

• changes in fiscal policy depend on where the original AD of the economy was (if there is spare capacity or not)

shape of the LRAS explanation

• an expansions fiscal policy will only have a temporary effect and will lead to inflation (if a classical model when the LRAS is straight up)

• so a classical economist will not often use fiscal policies

fiscal surplus

tax revenue is greater than gov spending

balanced budget

tax revenue is equal to gov spending

fiscal deficit

tax revenue is less than gov spending