Evaluation of fiscal policy

USING RWE’S, EVALUATE THE VIEW THAT FISCAL POLICY IS AN EFFECTIVE WAY OF ACHIEVING MACROECONOMIC OBJECTIVE. (15 MARKS)

Ways of evaluating micro policies:

• Micro objectives - are there conflicts?

• Ability to use - can it always be used in all contexts?

• Speed of impact - is tit quick?

• Size of impact - how much is it?

1) Definitions:

Fiscal policy is the set of government policies related to government spending and taxation.

2) RWE:

In 2020 in the UK, the govt increases G on healthcare and benefits (through the furlough scheme) to increase economic growth and keep unemployment low.

3)Diagram + annotation

4) Arguements

Fiscal policy is effective at achieving some macroeconomic objectives. However, it cannot achieve them all at once. Increase in growth (Y → Y1), less unemployment (increase in Y → in demand for labour, increase in inflation (P→P1), increase government debt (gov borrows to increase G).

RWE: after the pandemic ended, the UK gov was left with above target inflation and very high govt debt.

To overcome this, govt must use contractionary policy. Decrease debt but also decrease growth. It depends on the problem the govt is trying to solve. Fiscal policy can overcome recession or reduce inflation… but cannot overcome both at the same time.

RWE: increase in gas prices (2023), increase inflation and decrease in growth. Fiscal policy (a demand side policy) cannot solve both problems at once (a supply side policy).

RWE: recession (2020). Only problem is a decrease in growth, so fiscal policy is effective.

Advantage of fiscal policy → long term benefits

Conclusion: it depends on what problem govt is trying to solve. It is effective at increasing growth during a recession, but it is less effective if govt debt is already very high or inflation is high at the same time.

Other evaluative arguements: the crowding out effect

Theory: there is only a finite amount of money available for people to borrow.

• Govt wants to increase G to increase AD

• To do that, the govt must borrow more money

• If govt borrows more, there is less available for firms to borrow

• Increase in G has crowded out firms investment

• Decrease in I → decrease in AD

Fiscal policy will cause less of an increase in AD … it is ineffective

Market for loanable funds → money that banks lend

Expansionary fiscal policy (increase in G)

Aim: increase AD. Output increase (Y → Y1)

• To do this, they borrow from banks, meaning they demand more loanable funds.

• Increase in D in the loanable funds market causes increase in interest rate.

• Firms are now less likely to borrow

• Decrease in I → decrease in AD (crowding out)

Fiscal policy is less effective

Reality: crowding out effect is not significant - govt can borrow from banks in other countries. There will be no effect on domestic firms.

Other evaluative arguements: The multiplier effect

Theory: when the govt spends, someone else receives that money as income.

• Increase in G on a new school building (£1m) increase in AD by £1m

• Building company workers receive £1m

  • they save £200k more

  • £200k is taken as tax

  • £100k more is spent on imports (all above leaked)

• The other £500k is spent on domestic goods (increase in C by £500k). Increase in AD by £500k

• Staff in shops receive £500k → even more increase in C.

Reality: multiplier effect is very small during a recession because confidence is low. Consumers are unlikely to spend the additional income they receive from the govt.