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AS Tutorial on Fiscal Policy

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Slide 1:

Chapter 19 Fiscal Policy

Slide 2:

The meaning of fiscal policy Fiscal policy is the term used to describe changes in taxation and government spending to meet macroeconomic objectives It has been used to influence AD but is increasingly being used to influence AS Fiscal policy has a much less important role compared to monetary policy where demand management is concerned Fiscal policy is mainly used for fine-tuning the supply side of the economy at a microeconomic level

Slide 3:

The meaning of fiscal policy This diagram shows the UK government’s forecast sources of income for 2007-8 It also shows their expenditure over that same period Often changes over time are due to changes in government policy It will depend on that particular government’s views about what is best for society and what changes are occurring in the macroeconomic performance It will try to correct negative externalities by providing public goods and merit goods Different governments will have different ideas on spending in areas like health, education and defence

Slide 4:

The meaning of fiscal policy There are features of fiscal policy called automatic stabilisers For example An upturn in the economy will automatically generate more revenue in the form of income tax, excise duties and VAT Reduced unemployment leads to less spending on social security benefits The key date in the year for the fiscal policy is the day of the Budget (March) when the Chancellor of the exchequer outlines spending and tax rates Automatic stabilisers – features of government spending and taxation that minimise fluctuations in the economic cycle

Slide 5:

Taxation and fiscal policy Taxation is the key source of government revenue Key types of tax are Income taxes and personal allowances Social security payments such as National Insurance VAT Excise duties (on alcohol, petrol and tobacco) Any increase in spending on the fiscal side has a direct impact on AD though some increases may have a greater impact upon aggregate supply AD = C + I + G + (X-M) increase

Slide 6:

Government spending and fiscal policy A large proportion of national income is spent by the government The difficulty is in deciding how much government spending is necessary to promote an optimum allocation of resources Spending can be divided into 3 areas Current spending – day to day running of public sector activities including materials used in schools and hospitals as well as wages of public sector workers Capital spending – improving the productive capacity of the economy such as investing in infrastructure like roads, railways, school and hospitals. Transfer payments – Jobseeker’s allowance, disability benefits etc

Slide 7:

Fiscal policy and budget deficits and surpluses A budget deficit occurs whenever government spending exceeds revenue from taxation and other sources A budget surplus is when revenue exceeds expenditure A balanced budget is when revenue equals expenditure A deficit can be eliminated by cutting public expenditure. If a deficit persists it has to be financed with borrowing This borrowing is known as the PSNCR – the public sector net cash requirement

Slide 8:

Fiscal policy and budget deficits and surpluses A budget surplus or public sector debt repayment (PSDR) means that the government can use the excess revenue to repay borrowing The amount that the government has to borrow is determined by what is happening in the economy as a whole Watch this video – its from 2010 but it is relevant http://news.bbc.co.uk/2/hi/programmes/the_daily_politics/8545573.stm In 2010 the UK government had borrowed 175 Billion which is 12.6% of GDP – a peace time record The problem is that the government felt it needed to keep spending to prop up AD

Slide 9:

The government’s budgetary position and the economic cycle The government’s position – deficit, surplus or balanced budget will change with the economic cycle During an upturn Tax revenues will expand as incomes rise taking money out of the circular flow Welfare spending will decrease on means tested benefits such as unemployment and income support During an upturn the government may be able to run a surplus or at least reduce the deficit During a downturn the opposite will happen This should mean that a government in theory should be able to balance its budget over the course of the economic cycle Tax revenues expand taking money out of the circular flow. Welfare spending decreases Tax revenues reduce (injection). Welfare spending increases

Slide 10:

Demand-side fiscal policy Discretionary fiscal policy – the deliberate manipulation of government spending and taxation to influence the economy E.g. a decision to increase resources to the NHS Government essentially has tow options Cut taxes or Increase expenditure Both of these are expansionary fiscal policy – policy that stimulates AD during a downturn A decrease in tax means more take home pay More will be spent Consumer spending will rise and AD will increase shifting the curve from AD1 to AD2 The proportion spent will depend on the marginal propensity to consume ( evaluation point)

Slide 11:

Demand-side fiscal policy If government increases expenditure on national road building Pay of engineers and construction workers will increase A large proportion will be spent (depends on propensity to consume) Demand for goods and services increases supply Increased supply means more demand for labour Government spending leads to larger increase in circular flow What is this called? Multiplier

Slide 12:

Demand-side fiscal policy The issue is that the multiplier effect is very difficult to measure - no one knows how quickly money will move around the economy another evaluation point – no-one knows how much the stimulation will shift AD because the multiplier effect is so difficult to forecast. Therefore stimulation may not be beneficial to the economy. Government needs to be careful to be careful not to stimulate too much. If it boosted it to AD3 this would cause demand pull inflation.

Slide 13:

Demand-side fiscal policy To slow down economic growth e.g. during a boom when AD outstrips the productive capacity of the economy contractionary fiscal policy will be used It is used to counter inflationary pressure Government will reduce spending and increase taxation Withdrawals from the circular flow should reduce AD increased by the multiplier effect AD will shift from AD3 to AD2 or AD1 depending on the size of the reduction in spending or increase in taxation. Complete activities on P220 and 221

Slide 14:

The multiplier At AS we just need a general understanding of this – no numerical working! If the government extends an existing motorway and spends £1bn This will generate more income for contractors Contractors will spend part of their additional income (but will save some too) This income will be spent on firm’s goods and services These firms will spend the income they have received and so on

Slide 15:

The multiplier The extra income spent will depend on the marginal propensity to consume (or save) The income in the circular flow is multiplying hence the multiplier effect In very simple terms if the value of the multiplier is 2 then every £1bn injection into the circular flow of income there will be an overall £2bn increase in the equilibrium national income The reverse will happen if government reduces spending or increases tax (negative multiplier effect)

Slide 16:

Supply-side fiscal policy Fiscal policy can also have an impact on AS Changes can affect the supply-side capacity of the economy and contribute to long term growth Labour market incentives Income tax cuts – gives incentives for people to actively search for work Less income tax may given an incentive for those in work to work harder Although people may actually work less for the same take home pay Many workers are unable to chose the hours they work Many economists argue that it is better to reform welfare benefit (create a gap between those who are working and those voluntarily unemployed) than play with income tax

Slide 17:

Supply-side fiscal policy Capital Spending (spending on investment to improve the quality of resources) Government spend more on improving infrastructure particularly transport Lower rates of corporation tax to stimulate higher levels of business investment and attract inward investment from overseas Entrepreneurship – government spends to fund new small business start-ups (grants)

Slide 18:

Supply-side fiscal policy Research and Development and Innovation Government spending, tax credits and other tax allowances used to encourage more R&D This will hopefully improve international competitiveness of domestic businesses and Contribute to a faster pace of innovation and invention Improvements in human capital Increased government spending on education and training (boost the human capital of the workforce) Increase investment in health (improve resources)

Slide 19:

Supply-side fiscal policy What we are trying to achieve with all of these policies is to shift the LRAS to the right (shift the PPB) We will increase the productive capacity of the economy Since output rises in line with AD (we will only produce more goods and services if there is demand) we can avoid inflationary pressure Prices may fall in some markets because good and services can be produced more efficiently

Slide 20:

Free market economists Free market economists are sceptical of the effects of government spending in improving the supply side of the economy They argue that lower taxation and tighter control of government spending/borrowing is required to allow the private sector to flourish The tax burden should come down to allow the private sector to grow Targeted government spending and tax decisions can have a positive impact but it will take a long time to take effect The key is to help provide the right incentives for individuals (to find work) and business (to invest) Good critical analysis – use it as an alternative suggestion) Read Case study P223 and complete the activity Complete stretch and challenge P224

Slide 21:

Essay Discuss the impact of an increase in government expenditure on UK economic performance Remember to think about this from both a demand and supply side perspective Think about the 2 diagrams you could draw Start with one, analyse and evaluate Then move onto the next What does each of them of them do to the 4 macro objectives? Remember the impact of capacity in the economy Think about the two ways that government gets the money to spend – do these have an effect on the outcome? Don’t forget to include some UK specific info (have a look online at government spending today)

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