Fiscal Policy Measures (Cambridge International IGCSE Economics)
Fiscal Policy Defined
Spec point — definition of fiscal policy
-
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
Spec point — How fiscal policy measures may enable the government to achieve its macroeconomic aims. Note: aggregate demand and aggregate supply are not required.
-
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 |
|---|---|
| Effect on the economy | Consumers pay more tax → discretionary income reduces → consumption reduces → total demand reduces |
| Impact on macroeconomic aims | - Economic growth slows down - Inflation eases - Unemployment may increase as output is falling and fewer workers are required - Current Account Improves (with less income, imports may fall) |
| Example 2 | The Government freezes/reduces public sector workers pay |
|---|---|
| Effect on the economy | Wages stagnate or reduce → Consumer confidence falls → consumption decreases → total demand decreases |
| Impact on macroeconomic aims | - Economic growth slows down - Inflation eases - Unemployment may increase as output is falling - Current Account Improves (with less income, imports may fall) |
| Example 3 | The Government cuts Government spending in their Budget |
|---|---|
| Effect on the economy | Less demand for goods/services → less income for firms → output and profits decrease → total demand decreases |
| Impact on macroeconomic aims | - Economic growth slows down - Inflation eases - Unemployment may increase as output is falling - Current Account Improves (with less income, imports may fall) - Less corporation tax available for redistribution |
Examples of the Impact of Expansionary Fiscal Policy
| Example 1 | The Government decreases corporation tax |
|---|---|
| Effect on the economy | Firms net profits increase → investment by firms increases → total demand increases |
| Impact on macroeconomic aims | - Economic growth increases - Inflation rises - Unemployment may decrease as output is rising which requires more workers - Current Account- unsure - exports may rise due to new investments in the economy, but imports may rise due to higher income generated by the investment |
| Example 2 | The Government increases unemployment benefits |
|---|---|
| Effect on the economy | Household income increases → consumption increases → total demand increases |
| Impact on macroeconomic aims | - Economic growth increases - Inflation rises - Unemployment may decrease as output is rising which requires more workers (although increased unemployment benefits may discourage some people from entering the labour market) - Current Account unlikely to change as this policy helps the poorest and imports are unlikely to increase - Redistribution of income has increased and there is more equity in society |
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
Was this revision note helpful?
Build on this topic