Fiscal Policy

Definition of Fiscal Policy. Fiscal policy involves the Government changing the levels of Taxation and Government spending in order to influence Aggregate Demand (AD) and therefore the level of economic activity.

(AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)

The purpose of fiscal policy:

Keep inflation low, (UK government has a target of 2%)
Stimulate economic growth in a period of a recession.
Basically, fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic cycle.

Fiscal Stance:

This refers to whether the govt is trying to increase AD or decrease AD.

Expansionary (or loose) Fiscal Policy

This involves trying to increase AD.
Therefore the govt will increase spending (G) and / or cut taxes. Lower taxes will increase consumers spending because they have more disposable income(C)
This will increase the government's budget deficit.

Deflationary (or tight) Fiscal Policy

This involves trying to decrease AD.
Therefore the govt will cut govt spending (G); and or increase taxes. Higher taxes will reduce consumer spending (C).
This will lead to an improvement in the government budget deficit

Fine Tuning : This involves maintaining a steady rate of economic growth through using fiscal policy. However this has proved quite difficult to achieve precisely.

Automatic Fiscal Stabilisers

If the economy is growing, people will automatically pay more taxes ( VAT and Income tax) and the Government will spend less on unemployment benefits. The increased T and lower G will act as a check on AD.
In a recession the opposite will occur with tax revenue falling but increased government spending on benefits, this will help increase AD

Discretionary Fiscal Stabilisers

This is a deliberate attempt by the govt to affect AD and stabilise the economy, e.g. in a boom the govt will increase taxes to reduce inflation

Injections (J): This is an increase of expenditure into the circular flow, it
includes govt spending(G), Exports (X) and Investment (I)
Withdrawals (W): This is leakages from the circular flow This is household
income that is not spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M)

Note Fiscal Policy was particularly used in the 50s and 60s to stabilise economic cycles. These policies were broadly referred to as 'Keynesian' In the 1970s and 80s governments tended to prefer monetary policy for influencing the economy.
There are many factors which make successful implementation of fiscal policy difficult. See: Evaluation of fiscal policy

Government borrowing and fiscal policy

net-annual-borrowing

In 2008-09 we see a sharp rise in government borrowing. This is a consequence of the recession (lower tax receipts). Also, the government cut VAT to 15% in an attempt to stimulate economic activity.

Higher borrowing tends to increase aggregate demand (unless there is crowding out)

Lower borrowing tends to reduce aggregate demand

Brief history of UK fiscal Policy

In the 1920s and 1930s, the UK placed great emphasis on balancing the budget. However, Keynesian economics suggested this was a mistake. Keynes argued for expansionary fiscal policy in a recession.

Between 1945 to mid 1970s, the government sometimes used fiscal policy to manage demand. Fiscal policy fell out of favour until the 2008 recession.

See: UK fiscal policy for more details