Using the data and your economic knowledge, assess the possible consequences for the UK
economy of an EU-wide fiscal policy requiring all member states to balance their budgets
Extract D notes of the Conservatives’ policy of economic austerity which include significant ‘public
spending cuts and tax increases.’ Whilst this policy so far appears to have been successful in guiding
the UK economy out of recession, an EU-wide fiscal policy requiring all members to have a balanced
budget could have a greatly detrimental impact on the UK. In assessing the possible consequences of
such a policy, it is necessary to define exactly what a budget deficit is – a status of financial health
where the government is spending more (e.g. on public services) than they are receiving in revenue
(e.g. through taxes). Despite the UK government’s focus on austerity measures, the UK is still
currently operating with a very large budget deficit, at £91.3bn, already breaking the Stability and
Growth Pact’s limit of 3% of GDP. Thus the effect of an EU-wide fiscal policy on the UK would be
significant. In order to evaluate the macroeconomic impact, one must consider how such a policy
would affect the main UK macroeconomic aims; namely stable prices (the UK aims for a 2% target
inflation), low unemployment, rising economic growth and a sustainable balance of payments. An
EU-wide fiscal policy should have significant impacts on all four of these objectives, and the overall
effect on the UK economy is likely to be detrimental.
AD = C + I + G + (X – M)
In order to assess the impact of such a policy on the main macroeconomic targets, it is necessary to
analyse the effect of such a policy on aggregate demand (AD). The formula above is for measuring
the aggregate demand in an economy. As can be seen, government spending (G) is a key component
of AD. The likelihood is that if the UK was required to balance its budget, it would do so through
both methods available - by raising taxes and through reducing government spending. Thus a policy
that required the balancing of the UK budget deficit would directly decrease aggregate demand as
government spending is a key component of it. Moreover, if the government raises taxes then this
would reduce the disposable income of consumers, and thus is likely to reduce consumption.
Furthermore, if corporation taxes were increased (a likely situation seeing as corporation tax
accounted for £41.9bn of total government revenue in 2013), then it is likely that the UK would
experience a fall in the level of investment as firms receive lower profits due to higher tax rates.
Investment is another key component of AD, and thus a decrease would be further detrimental to
UK aggregate demand.
First let us assess the impact on inflation. As can be seen in Fig 1, the expected decrease from AD1 to
AD2 will, in theory, lead to a decrease in the price level from P1 to P2, signalling downwards
inflationary pressure. Whilst many economies are threatened by high levels of inflation, deflationary
pressures would currently have a detrimental impact on the UK economy. The UK economy is
experiencing a period of very low inflation with the latest figure of 0.5% for December being the
joint lowest on record. Although this deflationary pressure has been primarily caused by the drastic
fall in the price of oil over the past months and thus is expected to soon pick up again, fiscal
tightening could cause unwarranted deflationary pressure, and even comes with a risk of deflation
itself. Deflation is a very worrying prospect due to its self-perpetuating nature (like Japan has
experienced for the past decades), and thus this would be very detrimental to the UK economy.
Moreover, with the rest of the EU experiencing low inflation rates, an EU-wide fiscal tightening
economy of an EU-wide fiscal policy requiring all member states to balance their budgets
Extract D notes of the Conservatives’ policy of economic austerity which include significant ‘public
spending cuts and tax increases.’ Whilst this policy so far appears to have been successful in guiding
the UK economy out of recession, an EU-wide fiscal policy requiring all members to have a balanced
budget could have a greatly detrimental impact on the UK. In assessing the possible consequences of
such a policy, it is necessary to define exactly what a budget deficit is – a status of financial health
where the government is spending more (e.g. on public services) than they are receiving in revenue
(e.g. through taxes). Despite the UK government’s focus on austerity measures, the UK is still
currently operating with a very large budget deficit, at £91.3bn, already breaking the Stability and
Growth Pact’s limit of 3% of GDP. Thus the effect of an EU-wide fiscal policy on the UK would be
significant. In order to evaluate the macroeconomic impact, one must consider how such a policy
would affect the main UK macroeconomic aims; namely stable prices (the UK aims for a 2% target
inflation), low unemployment, rising economic growth and a sustainable balance of payments. An
EU-wide fiscal policy should have significant impacts on all four of these objectives, and the overall
effect on the UK economy is likely to be detrimental.
AD = C + I + G + (X – M)
In order to assess the impact of such a policy on the main macroeconomic targets, it is necessary to
analyse the effect of such a policy on aggregate demand (AD). The formula above is for measuring
the aggregate demand in an economy. As can be seen, government spending (G) is a key component
of AD. The likelihood is that if the UK was required to balance its budget, it would do so through
both methods available - by raising taxes and through reducing government spending. Thus a policy
that required the balancing of the UK budget deficit would directly decrease aggregate demand as
government spending is a key component of it. Moreover, if the government raises taxes then this
would reduce the disposable income of consumers, and thus is likely to reduce consumption.
Furthermore, if corporation taxes were increased (a likely situation seeing as corporation tax
accounted for £41.9bn of total government revenue in 2013), then it is likely that the UK would
experience a fall in the level of investment as firms receive lower profits due to higher tax rates.
Investment is another key component of AD, and thus a decrease would be further detrimental to
UK aggregate demand.
First let us assess the impact on inflation. As can be seen in Fig 1, the expected decrease from AD1 to
AD2 will, in theory, lead to a decrease in the price level from P1 to P2, signalling downwards
inflationary pressure. Whilst many economies are threatened by high levels of inflation, deflationary
pressures would currently have a detrimental impact on the UK economy. The UK economy is
experiencing a period of very low inflation with the latest figure of 0.5% for December being the
joint lowest on record. Although this deflationary pressure has been primarily caused by the drastic
fall in the price of oil over the past months and thus is expected to soon pick up again, fiscal
tightening could cause unwarranted deflationary pressure, and even comes with a risk of deflation
itself. Deflation is a very worrying prospect due to its self-perpetuating nature (like Japan has
experienced for the past decades), and thus this would be very detrimental to the UK economy.
Moreover, with the rest of the EU experiencing low inflation rates, an EU-wide fiscal tightening
