See the previous revision notes on 2.4 Fiscal Policy – The government budget here.
Fiscal policy and short-term demand management
Fiscal policy – it is the use of government expenditure and tax rates to influence aggregate demand.
Expansionary fiscal policy – increasing government expenditure and/or decreasing taxes to increase aggregate demand. Used in attempts to close deflationary (recessionary) gaps.
Contractionary fiscal policy – decreasing government expenditure and/or increasing taxes to decrease aggregate demand. Used in attempt to close inflationary gaps.
Most economies have built-in stabilisers like unemployment benefits and progressive taxes. When GDP grows, unemployment falls and wages rise. Lower unemployment means less government spending on unemployment benefits and higher wages (as well as more working people who pay taxes) mean more government income from progressive taxes. As GDP falls, governments increase their spending on unemployment benefits and tax revenue falls (because of falling wages and growing number of unemployed workers).
Fiscal policy and its impact on potential output
Fiscal policy can be used to create an environment for long-term economic growth:
- Investing in infrastructure (government-owned capital necessary for economic activity to take place) e.g. roads, power stations, etc.
- Preparing the economy: liberalising laws for setting up business or hiring/firing workers. That makes private firms more likely to invest and set up business in the country.
- Providing incentives for firms to invest: for example, lower corporate tax rate is the obvious incentive.
Evaluation of fiscal policy
Strengths of the fiscal policy:
- It can target certain sectors of the economy
- Government expenditure is a direct impact on the AD (it changes, various determinants only influence the size of the effect)
- It is highly effective in a recession
- Small time lags (e.g. taxes are decreased, workers have more disposable income the very next payday -> consume more right away.) Yet, this point is debatable!
Weaknesses of the fiscal policy:
- Political influence: where the government expenditure goes and taxes can be used by politicians for electoral purposes
- “Crowding out” – governments borrow to increase their expenditure and offer a high interest rate on their bonds. Private sector, in order to compete with the government, increases its interest rate, thus discouraging private investment. This is how government spending “crowds out” private investment.
- If taxes are decreased, people might start saving the extra income and the expansionary fiscal policy does not work (or its effect is smaller). That might happen because of belief that in the future taxes might go even higher than before, to compensate for possible losses now.