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Study Notes

Fiscal Policy - Managing Aggregate Demand and Inflation

AQA, Edexcel, OCR, IB

Last updated 22 Mar 2021

Government spending, direct and indirect taxation and the budget balance can be used “counter-cyclically” to help smooth some of the volatility of national output when an economy has experienced an external shock

  • Discretionary fiscal changes are deliberate changes in taxation and Govt spending – for example a decision by the government to increase total capital spending on road building.
  • Automatic fiscal changes (‘automatic stabilisers’) are changes in tax revenues and state spending arising automatically as the economy moves through the trade cycle.

During phases of high GDP growth, automatic stabilizers reduce the growth rate and avoid the risks of an unsustainable boom and accelerating inflation. With higher growth, a government will receive more tax revenues and there will be a fall in unemployment so the government will spend less on unemployment and other welfare benefits. In some cases, a government may run a budget surplus during a boom that acts as a net leakage of demand from the circular flow.

In a recession, because of lower real incomes and a contraction in employment, people and businesses pay less tax, and spending on welfare benefits will increase. The result is an automatic increase in government borrowing with the state sector injecting extra demand into the circular flow.

Recent evidence from the OECD suggests that a government allowing the fiscal automatic stabilizers to work might reduce the volatility of an economic cycle by up to 20 per cent. The strength of the automatic stabilizers is linked to the size of government spending as a % of GDP, the progressivity of the tax system and how many welfare benefits are income-related. In short automatic stabilizers help to provide a cushion of demand in an economy and support output during a recession.

Keynesian economists argue that an active use of expansionary fiscal policy beyond relying solely on the automatic fiscal stabilisers is needed to bring a recovery in demand, production, investment and jobs.

Measuring the fiscal stance

  1. A ‘neutral’ fiscal stance might be shown if the government runs with a balanced budget.
  2. A reflationary fiscal stance happens when the government is running a budget deficit.
  3. A deflationary fiscal stance happens when the government runs a budget surplus (i.e. G<T)

Keynesian justification for a fiscal stimulus

  • The Keynesian school argues that fiscal policy can have powerful effects on AD, output and employment when an economy is operating below full capacity national output
  • Keynesians believe that a government should make active use of fiscal policy measures to fine-tune aggregate demand particularly when monetary policy is proving ineffective. Here is the justification:
  • There is an automatic rise in the budget deficit to cushion the fall in AD caused by a shock such as the credit crunch. A higher deficit is needed to lift AD back towards pre-recession levels
  • If this works the budget deficit will improve as a result of higher tax revenues and reductions in welfare spending. A growing economy helps to shrink government debt
  • Keynesian economists oppose cutting government spending during a recession

Monetarist economists believe that government spending and tax changes can only have a temporary effect on AD, output and jobs and that monetary policy is more effective in controlling AD and inflation.

The Fiscal Multiplier Effect

The fiscal multiplier measures the final change in national income that results from a deliberate change in either government spending and/or taxation. Several factors affect the likely size of the fiscal multiplier effect.

  • Design: Evidence from the OECD is that multiplier effects of increases in spending are higher than for tax cuts or increased transfer payments.
  • Who gains from the stimulus? If tax reductions are targeted on the low paid, the chances are they will spend it adding to aggregate demand
  • Financial stress: Uncertainty about job prospects, future income and inflation levels might make people save tax cuts. On the other hand if consumers are finding it hard to get credit, they may decide to consume a high % of any boost to their disposable incomes.
  • Temporary or permanent fiscal boost: Expectations of the future drive behaviour today - most of us now expect taxes to rise in the coming years. Will this prompt a higher household saving and a paring back of spending and private sector borrowing?
  • The availability of credit:If fiscal policy works in injecting fresh demand, we still need the banking system to supply sufficient credit to businesses who need to borrow to fund an increase in production (perhaps for export) and investment in fixed capital and extra stocks.
  • Openness of the economy: The more open an economy is (i.e. the higher is the ratio of imports and exports to GDP) the greater the extent to which higher government spending or tax cuts will feed into rising demand for imports, lowering the impact on domestic GDP.
  • Fiscal and monetary policy decisions in other countries for example a period of fiscal austerity in euro zone countries might dampen an economic recovery in the UK at least in the short term

Problems with Fiscal Policy as an Instrument of Demand Management

  1. Recognition lags: It takes time to for policy-makers to recognise a need for changes in spending or taxation.
  2. Imperfect information: Key data on the economy is often delayed and subject to revisions.
  3. Response lags: It takes time to implement an appropriate policy response. Tax cuts can feed through quickly but new capital expenditure is difficult to start; roads have to be planned, hospitals and schools designed – the response lags may run into years not months

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