Fiscal Policy

- Changes in taxation and government spending are called the Fiscal policy, this is influenced by
economic activity and it affects the growth of Aggregate Demand.
- If the government is spending more than the taxation is receives then the government is said to
be operating a Fiscal/Budget Deficit.
- If the government is spending less than the taxation is receives then the government is said to
be operating a Fiscal/Budget Surplus.

- A Budget deficit puts spending power into the economy with a positive multiplier effect.
- A Budget surplus puts spending power out of the economy with a negative wealth effect.
- An increase in tax or a cut in spending would lead to a decrease in AD with multiplier effects.
- A decrease in tax or an increase in government spending would lead to an increase in AD with
multiplier effects.
- Expansionary Fiscal Policy = When the government spend more then it receives in order to
stimulate the level of spending in the economy in order to increase AD.

- Contractionary Fiscal Policy = When the government spend less than they receive in order to
dampen the level of spending in the economy which causes a decrease in AD.


The Economy is in a slowdown or
recession. There is no economic
growth, unemployment is rising and
business are going bankrupt.
So the government wants to expand
economic activity by creating more
demand in the economy.
(EXPANSIONARY F.P)
So the government decide to spend more
money itself. It could spend this money on
a variety of sectors e.g. education, building
hospitals etc. Spending extra money
meant that this would create jobs in the
industry e.g. construction. Or by giving
people more benefits will also increase
their incomes which would inturn increase
their spending.
Alternatively, the government could
cut taxes. this will give every tax
payer some money back - the effect
is the same as increase in spending,
as people have more money in their
pockets.
When people have higher incomes they
will spend some of their extra money
they have, spending more will boost
demand for goods and services across
the economy and will create new jobs.
This itself will lead higher incomes and
more spending, is called a POSITIVE
MULTIPLIER EFFECT
The P.M.E means that the economy
has been boosted. Economic growth
goes up and unemployment falls. But
this may cause an increase in
inflation! Also the government now
has a large Budget Deficit.
The Economy is growing too fast.
Inflation is rising, We are stuck in too
many imports so the Balance of
Payment is in a deficit.
So the government wants to contract
or deflate economic activty by
having less demand in the economy.
(CONTRACTIONARY F.P)
So the government decide to spend less
money itself. It could do this by cutting
spendings on a variety of sectors e.g.
education, building hospitals etc. Spending
less money meant that people would
notice that their income has fallen or that
there are fewer jobs in areas like
contruction.
Alternatively, the government could
raise taxes. this will mean that every
tax payer losses some money, this
would make everyone feel a little bit
poorer
When people have lower incomes
they will spend less money, spending
less will cut demand for goods and
services across the economy. This
itself will lead lower incomes and is
called a NEGATIVE MULTIPLIER
EFFECT
The N.M.E means that the economy
has been reduced. Economic growth
goes down and inflation falls. But
this may cause an increase in
unemployment! Also the
government now has a large Budget
Surplus.
Evaluation:
Time Lag: How long does it take the government to realise the economy is in a recession? The fiscal
measures take time to be put into effect, during which the economy can change, which the
government may not have anticipated as.
Multiplier: A tax cut or spending increase might not boost the economy if most people save their
extra income, instead of spending it. This would mean that the Marginal propensity of consumed
was low, not high. The money wont get passed around the economy to boost national income. The
same is true if people spend all their disposable income on imports. This reduces the multiplier
effect and makes fiscal policies less effective in achieving more employment and growth.
Crowding out: The crowding out view is that a rapid growth of government spending leads to a
transfer of scarce productive resources from the private sector to the public sector. For example the
government may seek to increase AD by reducing taxations or by increasing government spending
this may lead to a budget deficit for the government, to pay for this deficit the government would
have to see its bonds to the private sector. Attracting individuals and businesses to purchase the
debt may require high interest rates. As interest rates rise may crowd out private investment and
consumption which will hurt economic growth in the long run.
Reaction to tax cuts/ Spending Increase (Ricardian Equivalence): If the government cut taxes too
boost spending, at some point in the future the government would have to raise its tax again in
order to pay off the deficit, so if the consumer is rational they would have realised that at some
point in the future they would have to higher tax, so they would have increased their savings now,
this is called the Ricardian equivalence.