Revision 3 - Fiscal policy

What is Fiscal policy Fine tuning?

Fiscal policy is when the government change its spending or tax levels to influence the economy.

Fine tuning means adjusting fiscal policy to stabilise the economy in the short run like nudging it back toward full employment(GDP) after a shock.

Two main types;

Expansionary fiscal policy; increase government spending or decrease taxes = boost demand during recession.

Contractionary fiscal policy; decrease spending or increase taxes = cools down inflation during a boom

Why is fine tuning hard to get right?

1. Time lags Three key lags

• Recognition lag - takes time to realise a recession/inflation is happening.

• Decision lag; political debates and approvals delay action

• Implementation lag - it takes time for money to hit the economy and have an effect.

2. Political constraints

• Government may act based on political motives, not economic logic

• Tax cuts are often politically easier than cutting spending

• Reversing policy is unpopular leading to persistent deficits

3. Uncertain Effects

• Economist don’t always agree on the multiplier - how much a change in spending / taxes affects GDP

• Behaviour of consumers and firms can be unpredictable

Debt and Deficit; What’s the problem?

Definitions:

• Budget deficit - when government spending exceeds revenue in a given year.

• National debt - the total of all past defects minus surpluses.

Why it matters:

Running deficits in a recession is normal and often necessary

But if deficits continue during normal or boom periods, Debt builds up

Large debt mean

• Higher interest payments (crowding out spending on other things)

• Potential loss of confidence in government bonds (especially for smaller economies)

• Pressure to raise taxes or cut spending later

Austerity; why some countries chose it

What is austerity?

• Policies aimed at reducing budget deficits through spending cuts and tax increases

Why use it

Debt crisis fear

Eurozone rulers

• EU countries are supposed to keep deficits and debt within limits

• Pressure from EU and ECB forces into austerity despite high unemployment

Confidence fairy

-some argued that cutting deficits would increase private sector confidence, boost investment, and lead to growth(controversial idea)