Fiscal Policy

Economics of Fiscal Policy

Fiscal Policy involves the Government changing the levels of Taxation and Govt Spending in order to influence Aggregate Demand (AD).
AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)

The purpose of Fiscal Policy is to:

Reduce the rate of inflation,
Stimulate economic growth in a period of a recession

Fiscal Stance:

This refers to whether the govt is increasing AD or decreasing AD

Expansionary (or loose) Fiscal Policy.

This involves trying to increase AD.

Therefore the govt will increase spending (G) and cut taxes. Lower taxes will increase consumers spending (C) (AD = C+ I + G + X – M) Therefore AD increases. This will worsen the govt budget deficit

Deflationary (or tight) Fiscal Policy

This involves trying to decrease AD:

Therefore the govt will cut govt spending (G) and increase taxes. Higher taxes will reduce consumer spending (C) This will lead to an improvement in the govt 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)

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