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Study Notes

Fiscal Policy - Growth and Development

AQA, Edexcel, OCR, IB

Last updated 22 Mar 2021

Fiscal policy involves the use of government spending, taxation and borrowing to affect the level and growth of aggregate demand, output and jobs

  • Fiscal policy is also used to change the pattern of spending on goods and services in an economy
  • It is also a means by which a redistribution of income & wealth can be achieved
  • It is an instrument of government intervention to correct for free-market failures such as negative externalities and the non-market provision of public goods
  • Changes in fiscal policy affect aggregate demand (AD) and aggregate supply (AS). The fiscal multiplier effect is important when discussing the impact of changes in fiscal policy on GDP

Government spending

Typically government spending in developed and developing countries is broken down into these areas

1.Transfer Payments:

  1. Welfare payments including cash payments paid through the social security system. Some of these might be made available in a universal way; others will be subject to some kind of means-test. Or they might be made conditional on people making certain choices such as ensuring that that the children in a family attend school or that a mother attends a post-natal or immunisation programme.
  2. Government subsidies to businesses including state aid to loss-making firms

2.Current Government Spending: i.e. state-provided goods & services provided on a recurrent basis - for example salaries paid to those working in a country’s education or health system

3.Capital Spending: Capital spending includes infrastructure spending such as new motorways and roads, hospitals, schools and prisons. This investment spending adds to the economy’s capital stock and can have important demand and aggregate supply side effects in the long term.

Economic and Social Justifications for State Spending

1.To provide a socially efficient level of public goods and merit goods and overcome market failure

  • Public goods and merit goods tend to be under-provided by the private sector
  • Improved and affordable access to education, health, housing and other public services can help to improve human capital, raise productivity and generate positive externalities

2.To provide a safety-net system of welfare benefits to supplement the incomes of the poorest in society – this is also part of the process of redistributing income and wealth. Government spending has an important role to play in controlling / reducing the level of relative poverty

3.To provide necessary critical infrastructure via capital spending on transport, education and health facilities – an important component of a country’s long run aggregate supply

4.Government spending can be used to manage the level and growth of AD to meet macro policy objectives such as low stable inflation and higher levels of employment

Government spending can be used in promoting equity and inclusive growth and development.

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