Revision Explanation notes

 Fiscal policy is a discretionary policy.  Fiscal policy involves manipulation by the govt for its own expenditures and taxes to influence AD or components of AD = C+I+G+(X-M)

 Current expenditure – daily running costs of gov departments  Capital exp – infrastuctures etc  Transfer payments - welfare

 Taxes = income, company, G+S taxes, customs  Sales of gov G+S – water/eleatricity/ transports  Sales of gov own assets

 In times of recessions- gov uses expansionary FP to stimulate AD  In times of booms – gov uses Contractionary FP to reduce AD this is done by changing the C, I, or G components of AD

 G = gov changes its own levels of spending by (spend more in recession, or less in boom)  C = changes income taxes to change disposable income – in recession reduce tax / in boom raise tax - so as Y rise C rises too.  I = changes to business taxes/ or subsidies to businesses can stimulate I or decrease I

 ( in boom increase T and reduce subsidies/ in recession reduce tax and increase subsidies to change cost of production for firms – increase S and O/P and increase employment

 In time of recession – eco experience recess gap – high U/E and low O/P and falling AD.  Changes in gov exp +T impact directly on AD how??  Raises disposable income and encourage production of more o/p  Thefore AD curve shift right to potential output. Eliminates rec gap

 If budget already in surplus – then surplus declines or shrinks to become a deficit  If budget in deficit – deficit increases ( this can be a problem)

 If gov chooses to reduce tax and increase exp at same time = revenues decline = budget goes into deficit  Need to subsidies exp either from borrowing or sales of gov assets both not desirable  Borrowing = increase foreign debt – impact BOP  Sales of gov assets – reduce future incomes for govt

 Can lead to inflationary pressures if AD is increased a lot more than increased o/p.  Both monetarists and Keynesian models predict this to happen as show in diagrams  Impact of FP will be rise in inflation which if monitored should be a positive sign that eco is recovering as long as inflation is not caused by S push factors – bcz it causes lower o/p and higher P.

 FP in boom times focuses in opposite to recession and aims to eliminate the inflationary gap and reduce AD by  Increase taxes  Reduce G The impact will be shift of AD left eliminating the inflationary gap and reduce prices.

 If govt increases T or reduces exp too much it may lead to recession or if T not raised high enough or exp reduced enough then AD may remain high. – why multiplier effect  Contractionary FP may also lead to only small fall in prices compared to fall in o/p as explained by Keynes

 If AD curve falls on the upward sloping AS curve prices will fall as well as GDP  If AD curve falls to the horizontal part of AS curve then GDP may fall by greater amount than fall in P.  It may also lead to Rachet effect with GDP falling whilst P remain the same – more likely representation of real life.

 Bcz it uses automatic stabilizers such as; progressive Y tax unemployment benefits Multiplier effect ensures that these stabilizers work in the eco. Where only small injection of G or lower T result in higher multiplied effect on GDP

 Gov must ensure it applies the correct level of exp or tax changes to produce the desired effect otherwise outcomes may be undesirable – eg: keeping eco in recession if not enough T cuts or exp are injected into eco or if less T increase or not enough cuts to exp – causing eco to remain overheating.  If too much are injected – the risk over stimulating the eco.

 Mainly determined by multiplier effect and the MPT and MPC as well as MPS and MPM  If MPC/ MPM is low – the more tax cut or a gov spending must be injected to stimulate eco.  If MPS – is high then the same will happen

 Levels of o/p – by spending on infrastructure, subsidies/ R&D to improve tech and productivity of lab  Spending directed to human devp – training and education  Incentives to encourage I – T concessions, subsidies

 Create stable eco environment for I and C  Gov policies encourage firms to invets in R& D  R&D enables better tech and increase productivity - cause a shift in LRAS curves  Creates a stable eco environment for firms to plan for Long term

 Pulling an eco out of recession ( bcz W and P may not adjust in SR ( sticky downwards - but if not then gov needs to intervene as Keynes suggested) – effective as seen in 2008 GFC  Dealing with rapid and escalating inflation – Contractionary FP

 Ability to target sectors of the economy – Eg; education, industry, infrastructure, heath – eg : Australia in 2008 – spending on renovating schools  Direct impact of gov spending on AD – especially direct spending but not so much Taxes because they may take time to take effect – if buss or Consumers are unsure about future  Ability to affect levels potential o/p – by creating stable macro eco enviro

1. Time lags – takes time for gov to recognize that recession or inflation is happening – due to waiting for data (quarterly figures)  Need to decide on appropriate policy to use – change taxes or exp ??  Policy takes time to take effect – min of 6-12 months

2. political constraints  GOV must get approval for its budget from political parties who may be opposed to increasing taxes or reducing welfare payments 3. Crowding out  If gov need to use expansionary FP and has budget deficit then need to borrow from domestic banks this may lead to crowding out of domestic investment

 As less money available to borrow – i/r may rise – not desirable in recessions.  Otherwise need to borrow overseas – raise foreign debt – not desirable for BOP

 Other weaknesses include: 3. Inability to deal with supply side causes of instability such as stagflation – with high inflation and low GDP – inflation better dealt with using tight MP 4. In recession T cuts may not be very effective if people feel insecure about future and save more instead of spending ie high MPS – therefore better to focus on increase spending instead

 5. inability to fine tune the eco – FP can lead the eco into a certain direction – ie reduce /increase AD but it cannot maintain AD at certain levels of O/p and p levels. WHY???  Bcz AD is influenced by many simultaneous factors that cannot all be controlled at same time