FISCAL POLICY
Meaning
Changes to government spending and taxation in order to influence AD
Reasons for using fiscal policy
Expansionary fiscal policy -> boost AD Contractionary fiscal policy -> reduce AD
to cool down the economy
Boost growth -> if the economy is in a Reduce inflation -> reduce demand pull
recession inflation
Reduce unemployment -> cyclical Reduce budget deficit/ National debt ->
unemployment will increase in a recession reduce the amount of annual borrowing
the government has to do
Increase inflation -> increase demand pull Redistribute income -> increase taxes on
inflation the rich
Re-distribute income -> reduce income Reduce current account deficit -> if AD is
inequality. Increased government spending reduced income will be reduced so there
on benefits will be less expenditure on imports
Examples of expansionary fiscal policy
1. Reduction in income tax
a. Could cut income tax for those in the higher
bracket or the lower bracket
b. In theory it will increase disposable income of Multiplier effect-> increase in
households in the economy which will increase the AD will lead to higher incomes
marginal propensity to consume and therefore in the economy which will lead
increase consumption which will boost AD to more spending which
2. Reduction in corporation tax increases AD and more
a. Increase retained profit which will increase spending leads to higher
businesses’ marginal propensity to invest which income
will boost investment in the AD equation
3. Reduction in regressive taxes
a. They place a higher burden on the poor and so if a tax such as VAT is reduced
it will increase disposable income for the poor
b. They have a higher marginal propensity to consume which will boost AD
4. Increased government spending
a. Increased spending on healthcare, education, public services will increase AD
Expansionary fiscal policy and LRAS- some policies boost the productive potential of the
economy as a side effect
Not the intention of expansionary fiscal policy
1. Reduction in income tax->
a. can incentivise the inactive in the population to become active-> i.e. will
incentivise people to enter the workforce.
, b. It will also encourage those in the workforce to work harder and for more
hours as they will be able to keep more of their income
2. Reduction of corporation tax
a. Investment boosts LRAS via an increase in the quantity and quality of factors
of production
b. It will also increase the productive potential in the economy
3. Increased government spending
a. Spending on education and health that
will boost the productivity and quality of
labour
b. Spending on infrastructure will boost the
productive efficiency and the quantity of
capital
Changes in LRAS are unintended effects of expansionary fiscal policy
Disadvantages of expansionary fiscal policy
*= trade off
Demand pull inflation* If inflation rises beyond the target then the outcome is not
desirable
Current account deficit* If economic growth increases that means higher incomes for
houses, which means more spending on imports which could
widen our current account deficit
Worsening of Government finances are likely to worse with expansionary
government finances fiscal policy. Budget deficits could rise (amount of government
borrowing per year) but also the debt that the government
has (National Debt) could increase
Key question- How will these policies be funded and will it
mean cuts to government spending in other areas of the
economy such as health ,education, welfare benefits or
infrastructure-> many people are reliant on these
->Could lead to higher taxation in the future however an
increase in income tax or corporation tax could harm long
term growth rates
-> Could lead to an increase in regressive taxation which could
burden the poor and widen income inequality
One alternative is that governments will accumulate a huge
debt, however this has a huge opportunity cost that comes
with paying debt interest
Ricardian equivalence-> if households know that the
government cannot afford expansionary fiscal policy in the
form of a cut in income tax then they may save the tax cut
now as they are expecting a tax rise in the future-> therefore
tax cuts will not have the desired outcome
Meaning
Changes to government spending and taxation in order to influence AD
Reasons for using fiscal policy
Expansionary fiscal policy -> boost AD Contractionary fiscal policy -> reduce AD
to cool down the economy
Boost growth -> if the economy is in a Reduce inflation -> reduce demand pull
recession inflation
Reduce unemployment -> cyclical Reduce budget deficit/ National debt ->
unemployment will increase in a recession reduce the amount of annual borrowing
the government has to do
Increase inflation -> increase demand pull Redistribute income -> increase taxes on
inflation the rich
Re-distribute income -> reduce income Reduce current account deficit -> if AD is
inequality. Increased government spending reduced income will be reduced so there
on benefits will be less expenditure on imports
Examples of expansionary fiscal policy
1. Reduction in income tax
a. Could cut income tax for those in the higher
bracket or the lower bracket
b. In theory it will increase disposable income of Multiplier effect-> increase in
households in the economy which will increase the AD will lead to higher incomes
marginal propensity to consume and therefore in the economy which will lead
increase consumption which will boost AD to more spending which
2. Reduction in corporation tax increases AD and more
a. Increase retained profit which will increase spending leads to higher
businesses’ marginal propensity to invest which income
will boost investment in the AD equation
3. Reduction in regressive taxes
a. They place a higher burden on the poor and so if a tax such as VAT is reduced
it will increase disposable income for the poor
b. They have a higher marginal propensity to consume which will boost AD
4. Increased government spending
a. Increased spending on healthcare, education, public services will increase AD
Expansionary fiscal policy and LRAS- some policies boost the productive potential of the
economy as a side effect
Not the intention of expansionary fiscal policy
1. Reduction in income tax->
a. can incentivise the inactive in the population to become active-> i.e. will
incentivise people to enter the workforce.
, b. It will also encourage those in the workforce to work harder and for more
hours as they will be able to keep more of their income
2. Reduction of corporation tax
a. Investment boosts LRAS via an increase in the quantity and quality of factors
of production
b. It will also increase the productive potential in the economy
3. Increased government spending
a. Spending on education and health that
will boost the productivity and quality of
labour
b. Spending on infrastructure will boost the
productive efficiency and the quantity of
capital
Changes in LRAS are unintended effects of expansionary fiscal policy
Disadvantages of expansionary fiscal policy
*= trade off
Demand pull inflation* If inflation rises beyond the target then the outcome is not
desirable
Current account deficit* If economic growth increases that means higher incomes for
houses, which means more spending on imports which could
widen our current account deficit
Worsening of Government finances are likely to worse with expansionary
government finances fiscal policy. Budget deficits could rise (amount of government
borrowing per year) but also the debt that the government
has (National Debt) could increase
Key question- How will these policies be funded and will it
mean cuts to government spending in other areas of the
economy such as health ,education, welfare benefits or
infrastructure-> many people are reliant on these
->Could lead to higher taxation in the future however an
increase in income tax or corporation tax could harm long
term growth rates
-> Could lead to an increase in regressive taxation which could
burden the poor and widen income inequality
One alternative is that governments will accumulate a huge
debt, however this has a huge opportunity cost that comes
with paying debt interest
Ricardian equivalence-> if households know that the
government cannot afford expansionary fiscal policy in the
form of a cut in income tax then they may save the tax cut
now as they are expecting a tax rise in the future-> therefore
tax cuts will not have the desired outcome
