3.6 Demand management - fiscal policy

• Fiscal policy is the use of taxation and government expenditure strategies to influence the level of economic activity to achieve the macroeconomic aims of low unemployment, sustainable economic growth and low inflation (price stability).
• Fiscal policy is a demand-side management.
• Fiscal policy is discretionary, meaning that it is purposively carried out by the government to influence the level of aggregate demand.
• Expansionary fiscal policy stimulates aggregate demand.
• Contractionary fiscal policy reduces the level of economic activity.
• Fiscal policy promotes long term economic growth and low unemployment through government spending on physical capital goods, government spending on human capital formation and provision of incentives for firms to invest.
• The source of government revenue is direct and indirect taxation, the sale of state-owned goods and services, and the sale of government assets.
• Government expenditure is a key component of aggregate demand.
• Current expenditure refers to government spending on goods and services consumed within the current year. Also known as consumption expenditure.
• Current expenditure is for immediate operations and includes wages for public sector employees, provision of subsidies, public sector debts, supplies for hospitals and schools.
• Capital expenditure refers to long term items of government spending that boost the economy's productive capacity.
• Capital expenditures are intended to create future benefits for all members of society.
• Examples of government capital expenditure include motorways, ports, and hospitals.
• Transfer payments are welfare expenses where there is no corresponding exchange of goods or services.
• Contractionary fiscal policy such as the use of higher tax rates or running a budget surplus reduces consumption, investment and government spending. Therefore AD shifts to the left.

  
• To achieve low unemployment, expansionary fiscal policy is used. It involves reducing taxes or increasing government expenditure. This increases the level of aggregate demand.
• To reduce the impacts of a recession the government can run a budget deficit (spending more than it gets in revenue). This is paid for using government borrowing.
• Progressive tax systems promote equitable distribution of income.
• The Keynesian multiplier shows that any increase in the value of injections into the circular flow of an economy results in a proportionately larger increase in aggregate demand.
• Injections in the circular flow model increase the value of the Keynesian multiplier.
• Marginal propensity to consume (MPC) measures the proportion of an increase in household income that is spent on goods and services rather than saved. $MPC=$$\frac{\Delta C}{\Delta Y}$
• Marginal propensity to import (MPM) measures the proportion of an increase in household income that is spent on imports rather than on domestically produced goods and services. $MPM=$$\frac{\Delta M}{\Delta Y}$
• Marginal propensity to save (MPS) measures the proportion of an increase in household income that is saved rather than spent on consumption or imports. $MPS=$$\frac{\Delta S}{\Delta Y}$
• Marginal propensity to tax (MPT) measures the proportion of each extra dollar of income earned that is taxed by the government. $MPT=$$\frac{\Delta T}{\Delta Y}$
• Keynesian multiplier = 1/(1-MPC) or 1/(MPS+MPT+MPM)
• Explain the difference between the marginal propensity to consume (MPC) and the marginal propensity to save (MPS).

  The MPC is the change in consumption as a result of a change in average household income, so reflects the portion of additional national income that is spent on consumption (an injection into the circular flow). By contrast, the MPS is the change in savings as a result of a change in national income, so reflects the portion of income that is saved (a withdrawal).
• Explain why the sum of MPC, MPS, MPT, and MPM equals 1.

  By definition, national income must be either spent on consumption and imports or be saved or taxed. Hence, the sum of all these parts must equal to 1 or 100% of national income.
• The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending due to the resulting rise in interest rates.
• Explain how crowding out limits the effectiveness of expansionary fiscal policy.

  When a government borrows money to finance public sector spending, often to address a budget deficit, the interest rate rises due to the relatively higher demand for loanable funds. That leads to reduction in private sector investment as firms would have to pay more due to a higher cost of borrowing. That is why the increased government spending balances out with a decrease in investment, limiting the effectiveness of expansionary fiscal policies.
• Discretionary fiscal policy is when the government is taking actions to change transfers or taxes to achieve its economic objectives.
• Automatic stabilisers are when government transfers and taxes that automatically increase or decrease along with the business cycle.