The Effectiveness of Fiscal Policy (DP IB Economics)

Strengths of Fiscal Policy

• Spending can be targeted at specific industries

• It can be highly effective in restoring confidence in an economy during a deep recession

• Redistributes income through taxation

• Reduces negative externalities through taxation

• Increased consumption of merit/public goods

• Short term government spending can lead to an increase in the aggregate supply of an economy

  • E.g. Building a new airport immediately increases government spending and AD, but when it is built, the potential output will have increased (Production Possibility Curve has shifted outward)
     

Automatic Stabilisers as a Strength of Fiscal Policy

• Automatic stabilisers are automatic fiscal changes that occur as the economy moves through stages of the business/trade cycle 

The impact of automatic stabilisers on an economy during a boom and recession

1. Effect in a recession

• In a recession, there will (automatically) be lower tax revenue due to the nature of progressive taxation - as incomes fall households are taxed less

• In a recession, as unemployment rises, the government will pay higher unemployment benefits / transfer payments which households will then be used for consumption

• Both of the above will result in real GDP being higher than it would otherwise have been
  

2. Effect in a boom

• In a boom, there will (automatically) be higher tax revenue due to the nature of progressive taxation - as incomes rise households are taxed more

• In a boom, as unemployment falls the government will pay less unemployment benefits / transfer payments which households which then does not get generate increased consumption

• Both of the above will result in real GDP being lower than it would otherwise have been

• This is effectively an automatic disinflationary effect

Weaknesses of Fiscal policy

• Political pressures: Policies can fluctuate significantly when new governments are elected 

  • Long term infrastructure projects may lack follow-through
     

• Unsustainable debt: Increased government spending can create budget deficits which are added to the national debt

  • Repaying this debt may lead to austerity on future generations
     

• Conflicts between objectives

  • E.g. Cutting taxes to increase economic growth may cause inflation
     

• Time lags: It is difficult to predict exactly when the desired effect on the economy will occur. Fiscal policy also takes a longer time to plan and implement than monetary policy

  • Government budgets are usually presented once a year whereas monetary policy adjustments can take place 4-8 times per year
     

Crowding Out as a Weakness of Fiscal Policy

• Crowding out refers to a phenomenon where expansionary fiscal policy, particularly government spending, can result in a reduction of private sector spending or investment
  
  

• Government borrowing results in competition with others in the economy who want to borrow the limited amount of savings available

  • This competition causes the real interest rate to rise and private investment decreases (is crowded out)
     

The diagram on the left shows how government borrowing increases interest rates, resulting in a fall in AD in the diagram on the right as private firms are crowded out of the market

Diagram Analysis

• Increased government borrowing causes the demand for money in the loanable funds market to increase from D_M1 →D_M2

• This extra demand raises interest rates from R₁→R₂

• The government increases their spending using the borrowed funds and aggregate demand in the economy increases from AD₁→AD₂

  • The increase in AD is greater than the actual value of the injection due to the Keynesian multiplier
     

• Private firms are put off from borrowing loanable funds due to the increased rate of interest and investment falls

  • As investment falls, aggregate demand decreases, shifting back to AD₃
     

• Private firms have been crowded out of the market by the governments actions