Fiscal Policy


    Fiscal policy is the manipulation of government expenditure (G) and taxation (T) by the government to influence macroeconomic variables.

    Government expenditure is total expenditure by the government on goods and services like merit goods (education and healthcare) and public goods (roads, the police, national defence and the law). Taxes are either direct or indirect. Direct taxes are taxes on consumers’ income (income tax) or firms’ profits (corporation tax). Indirect taxes are taxes on expenditure (VAT).

    The fiscal budget is tax revenue minus government expenditure . A balanced budget means so . A budget surplus means so . A budget deficit means so .

    Public Sector Net Cash Requirement Public sector net cash requirement (PSNCR) is government borrowing over a period of time, the difference between government expenditure and tax revenue. A budget deficit means G>T so the government must borrow funds to spend and the government goes into debt and the PSNCR is positive. A budget surplus means G<T so the government is receiving more tax revenue than it is spending and the PSNCR is negative.

    National Debt National debt is the sum of all the past unpaid government borrowing. Problems with a large national debt: – A large national debt means the government may increase taxes in the future to repay the debt, so there is an opportunity cost to future generations who must suffer higher taxes. – Maybe existing consumers decrease their own consumption to save and pay for an anticipated future tax increase, so AD falls and real GDP falls. – A large debt may be unsustainable because it means a higher risk of default, lower credit worthiness, higher interest rates and the debt spirals out of control. The government could become riddled with financial troubles. But, if the government borrowed to develop the infrastructure and education then LRAS shifts right, real GDP rises, the government’s tax revenue rises and it can repay its debt in the future.

    Expansionary and Contractionary Fiscal Policy An expansionary fiscal policy means so AD rises. Multiplier effects make AD rise further. AD shifts right so the price level rises and real GDP rises.

    Fiscal Policy influences AD through:

    1) Government Spending.

    A rise in government spending means there is more spending in the economy so AD increases.

    2) Income Tax.

    A fall in income tax means consumers’ real disposable income rises so consumption rises and AD rises.

    3) Corporation Tax.

    A fall in corporation tax means firms’ after-tax profits increase, so the profitability of investment rises, investment rises and AD rises.

    The Effectiveness of Fiscal Policy Fiscal policy’s effectiveness depends on many factors:

    1) Magnitude of Change in G and/or T.

    Fiscal policy is more (less) effective in raising AD the larger (smaller) the rise in G and/or the larger (smaller) the fall in T. A large rise in G and/or a large fall in T means AD rises a lot and shifts rightwards, the price level rises, real GDP rises and employment rises.

    2) Elasticity of LRAS.

    Fiscal policy is more (less) effective in raising AD, real GDP and employment the more elastic (inelastic) is LRAS.

    If LRAS is elastic there is a lot of spare capacity, an expansionary fiscal policy boosts AD, real GDP rises a lot, employment rises a lot but the price level rises a little bit (maybe stays the same).

    If LRAS is inelastic the economy is near full capacity, an expansionary fiscal policy makes AD, real GDP and employment rise a little bit (maybe stays the same) but the price level rises a lot.

    3) Short-Run vs. Long-Run.

    An expansionary fiscal policy increases AD, real GDP and the price level in the short-run and may increase LRAS in the long-run so the productive capacity of the economy rises, real GDP rises and the price level falls. More government spending on the infrastructure makes the economy more efficient so LRAS shifts right in the long-run. Also, as AD rises, firms’ profits rise, investment is more profitable, investment rises, more efficient machinery is developed so LRAS shifts right.

    4) Time Lags.

    Fiscal policy takes time to come into effect due to time lags. Fiscal policy must first be announced before G and T change. Also, it takes time for the multiplier to exert its full effect.

    5) Unsustainable Debt.

    The government cannot keep running a fiscal deficit because the government will build up debt that could become unsustainable. A level of debt too high means creditors will begin to fear that the government will default on its debt so creditors will charge the government a higher rate of interest. A higher interest rate means the government’s debt rises, the risk of default rises, credit worthiness falls, creditors charge the government higher interest rates and the spiral continues. Eventually the government must decrease government spending and increase taxation to repay the debt. AD will fall, real GDP falls and the economy falls into a recession.

    6) Ricardian Equivalence Hypothesis.

    If the government announce that government spending will rise, agents will anticipate higher taxes in the future because the government must eventually repay their fiscal deficit. Agents will thus decrease their consumption to save more so that they can repay the higher taxes they anticipate in the future. Government spending rises but consumption falls, so AD does not change and fiscal policy is ineffective.

    Automatic Stabilizers Automatic stabilizers are changes in government expenditure and taxation that automatically kick-in to help reduce the ups and downs of the business cycle. Two key automatic stabilizers are income tax and unemployment benefits. During a recession, income falls and unemployment rises. As income falls, workers pay less in income tax, so there is less of a drain on consumption than there may have been. As unemployment rises, more people receive unemployment benefits, so consumption does not fall by as much as it would have. During a boom the opposite happens.

    Crowding Out An expansionary fiscal policy may have no effect on real GDP if government spending crowds-out private investment. An increase in government spending will increase money and credit demand, increase the interest rate and decrease investment. AD shifts right because government spending rises but AD shifts left because investment falls. If there is complete 100% crowding out then the increase in government spending is cancelled out by the decrease in investment so AD does not move and real GDP does not change.

    Crowding In An expansionary fiscal policy may cause crowding-in, that is, it may cause private investment to increase. An increase in government spending will increase income and consumption so firms will increase investment to sell more and make more profit. Maybe an increase in government spending on the infrastructure decreases firms’ costs and incentivizes firms to increase investment to produce more to make more profit. AD shifts right because government spending rises and AD shifts right again because investment rises.



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