Fiscal Policy Measures (Cambridge (CIE) O Level Economics)
Revision Note
Written by: Steve Vorster
Reviewed by: Jenna Quinn
Fiscal Policy Defined
Fiscal Policy involves the use of government spending and taxation (revenue) to influence total (aggregate) demand in the economy
Fiscal policy can be expansionary in order to generate further economic growth
Expansionary policies include reducing taxes or increasing government spending
Fiscal policy can be contractionary in order to slow down economic growth or reduce inflation
Contractionary policies include increasing taxes or decreasing government spending
Fiscal Policy is usually presented annually by the Government through the Government Budget
A balanced budget means that government revenue = government expenditure
A budget deficit means that government revenue < government expenditure
A budget surplus means that government revenue > government expenditure
A budget deficit has to be financed through public sector borrowing
This borrowing gets added to the public debt
The Effects of Fiscal Policy on Government Macroeconomic Aims
To understand the effects of fiscal policy on an economy, it is useful to know how total demand (gross domestic product) is calculated
Total (aggregate) demand = household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
Total demand = C + I + G + (X - M)
From this, it is logical that changes to fiscal policy can influence any of these components - and often several of them at once
Examples of the Impact of Contractionary Fiscal Policy
Example 1 | The Government increases income tax levels |
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Effect on the economy | Consumers pay more tax → discretionary income reduces → consumption reduces → total demand reduces |
Impact on macroeconomic aims |
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Example 2 | The Government freezes/reduces public sector workers pay |
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Effect on the economy | Wages stagnate or reduce → Consumer confidence falls → consumption decreases → total demand decreases |
Impact on macroeconomic aims |
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Example 3 | The Government cuts Government spending in their Budget |
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Effect on the economy | Less demand for goods/services → less income for firms → output and profits decrease → total demand decreases |
Impact on macroeconomic aims |
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Examples of the Impact of Expansionary Fiscal Policy
Example 1 | The Government decreases corporation tax |
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Effect on the economy | Firms net profits increase → investment by firms increases → total demand increases |
Impact on macroeconomic aims |
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Example 2 | The Government increases unemployment benefits |
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Effect on the economy | Household income increases → consumption increases → total demand increases |
Impact on macroeconomic aims |
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Strengths of fiscal policy
Spending can be targeted on specific industries
Short time lag as compared with monetary policy (effects of fiscal policy are seen sooner)
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 total supply of an economy
E.g. Building a new airport immediately increases government spending and total demand, but when it is built, the potential output will have increased (Production Possibility Curve has shifted outward)
Weaknesses of fiscal policy
Policies can fluctuate significantly when new governments are elected
Long term infrastructure projects may lack follow-through
Increased government spending can create budget deficits
Repaying this debt may lead to austerity on future generations
Conflicts between objectives
E.g. Cutting taxes to increase economic growth may cause inflation
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