Fiscal policy

• Fiscal policy


  A macroeconomic policy that involves changes to government spending and taxation in order to influence aggregate demand in the economy
• Types of fiscal policy


  • Expansionary fiscal policy
  • Contractionary fiscal policy
• Expansionary fiscal policy


  • Changes to G and T that aims to boost aggregate demand
• Contractionary fiscal policy


  • Changes to G and T in order to reduce aggregate demand
• Expansionary fiscal policy


  Increases economic growth
• Expansionary fiscal policy


  Reduces cyclical unemployment
• Expansionary fiscal policy


  Increases demand-pull inflation
• Expansionary fiscal policy


  Redistributes income to reduce inequality
• Contractionary fiscal policy


  Cools down an overheating economy
• Contractionary fiscal policy


  Reduces the budget deficit and government debt
• Contractionary fiscal policy


  Redistributes income to reduce inequality
• Contractionary fiscal policy


  Reduces the current account deficit
• Expansionary fiscal policy


  • Aims to boost aggregate demand
• Expansionary fiscal policy

  Leads to a multiplier effect, increasing AD and economic growth further
• Expansionary fiscal policy - Tax policies


  • Reducing income tax
  • Reducing corporation tax
  • Reducing regressive taxation
• Expansionary fiscal policy - Government spending


  • Increasing spending on healthcare
  • Increasing spending on education
  • Increasing spending on infrastructure
  • Increasing public sector wages
• Expansionary fiscal policy


  Can also boost long-run aggregate supply as a side effect
• Reducing income tax


  Incentivises more people to join the labour force, increasing quantity of labour
• Reducing income tax


  Incentivises workers to be more productive, increasing quality of labour
• Reducing corporation tax


  Boosts investment, increasing quantity and quality of capital
• Increasing government spending on education and health

  Boosts productivity of labour, increasing quality of labour
• Increasing government spending on infrastructure


  Boosts productive efficiency, increasing quantity and quality of capital
• Expansionary fiscal policy


  Government policies that increase spending and/or reduce taxes to stimulate economic growth
• If expansionary fiscal policy is successful

  Aggregate demand will increase in the economy
• Increase in aggregate demand

  Can lead to higher economic growth and lower unemployment
• Increase in aggregate demand


  Can lead to higher demand-pull inflationary pressure
• Increase in incomes from economic growth


  Can lead to more spending on imports, widening the current account deficit
• Expansionary fiscal policy


  Likely to worsen government finances, leading to higher budget deficits and national debt
• Funding expansionary fiscal policy

  May require cuts to other government spending areas or increases in taxation, which can have negative impacts
• Households may save tax cuts rather than spend them, reducing the effectiveness of expansionary fiscal policy (Ricardian equivalence)
• Crowding out effect


  Debt-funded government spending can increase interest rates and reduce private sector investment
• 1. inefficiency


  Government spending can be wasteful and have excess costs, reducing its effectiveness
• Expansionary fiscal policy can have time lags before its full effects are felt in the economy
• Effectiveness of expansionary fiscal policy


  • Depends on the size of the output gap
  • Depends on the size of the multiplier effect
• Consumer and business confidence


  Can affect the impact of tax cuts, if they are saved rather than spent/invested
• Government finances


  The state of government finances before expansionary fiscal policy can affect its feasibility and impact
• Short-run increase in government debt from expansionary fiscal policy


  May be offset by long-run increases in tax revenues from higher economic growth
• Laffer curve


  Tax cuts can potentially increase tax revenues by improving incentives and reducing tax evasion
• Automatic stabilizers


  Can reduce the need for discretionary expansionary fiscal policy in a recession
• Keynesian view


  Expansionary fiscal policy can crowd in private investment in a recession, rather than crowding it out