13.2Demand management and fiscal policy

Fiscal policy involves the use of government spending and taxation to fulfil macroeconomic objectives by influencing AD. There are two types of fiscal policy

• expansionary fiscal policy
• contractionary fiscal policy

Fiscal policy can be used to promote long-term economic growth and reduce unemployment in three main ways

• Government spending on physical capital goods
• Government spending on human capital formation
• Provision of incentives for firms to invest
  • increase future productive capacity

Revenues and Expenditures

• Expenditures refer to money spent by governments, either through government spending (G) or transfer payments.
  • Transfer payments are payments made by the government without goods or services being received in return, such as welfare payments and donations.
• Current expenditures (short-term)
  • Wages for public sector employees
    Supplies for public sector businesses
    Interest payments for national debt
    The provision of subsidies and grants
• Capital expenditures (long-term)
  • infrastructure, quantity or quality of factors of production
• Revenues are allocated and earmarked to expenses through a government budget
  • Balanced: where expenditures = revenues
  • Surplus: where expenditures < revenues
  • Deficit: where expenditures > revenues

Governments earn money through direct and indirect taxation

• Direct taxes are imposed on income (rent, wages, interest, profit)
  • •Income
    tax
  • •Corporation
    tax
  • •Capital
    gains tax
• Indirect taxes are imposed on expenditure
  • sales tax
  • excise tax

Fiscal policy has six main objectives

• •Low
  unemployment
• •Promoting a stable economic environment for long-term growth
• •Low and stable inflation
• •Reducing
  business cycle fluctuations
• •Achieving
  an equitable distribution of income
• •Trade
  balance.

Expansionary Fiscal Policy

• increases AD by
  • Increasing government expenditure ”(↑G)“
    Decreasing direct and indirect taxation”(↑C, I)”
  • This is particularly important in Keynesian economics as economies may be stuck in a recessionary gap for long periods of time
• Any government spending which improves the quantity or quality of resources will improve AD and AS. For example
  • Government spending on physical capital goods and R&D which improves technology
    Government spending on human capital development through training and education
    Provision of incentives for firms to invest through lower business taxes
  • As a result, the productive capacity of the economy increases, shifting the aggregate supply curve outwards

  • 

Contractionary Fiscal Policy

• aims to reduce AD by
  • Decreasing government expenditure (”↓” G)
    Increasing direct and indirect taxation ”(↓C, I)”
• This can slow economic growth to a healthy level to prevent the economy from overheating. High levels of economic growth can cause
  • Undesirably high levels of inflation
  • shortages in labour market, the demand of labour is bigger the number of workers available

Evaluation of Fiscal Policy

• The strengths of fiscal policy include
  • Ability to target specific economic sectors
    • Fiscal policy can be used to correct regional disparities in income and spending habits
    • For example, tax cuts can be applied to low-income households, while marginal tax rates can be increased for high income households to redistribute income
    • Similarly, government spending can be targeted at the unemployed, retirees, those with disabilities or those with young children
  • “directly” Stimulates recovery from a deep recession
    • Government spending provides a direct injection of money into the circular flow of income
    • Expansionary fiscal policy can also help to increase confidence levels during a recession, increasing aggregate demand while providing further incentives for firms to continue employing their workers, avoiding further unemployment
• However, fiscal policy has its limitations
  • Political pressures
    • especially decreaseing G expenditures or increasing taxation
    • Political pressures prevent the use of contractionary fiscal policy such as higher taxes and less government spending as this may be politically unfavourable
  • Time lags
    • Recognition lag
      • It takes time to tell whether an economy is in need for government intervention
      • Furthermore, supply-side shocks can happen at any time, so it is difficult to plan and budget for shocks such as natural disasters and pandemics
    • Administrative lag
      • After identifying the need for government intervention, it will take more time to implement fiscal policy
      • Approval for tax changes
      • Changes to the government budget
    • Effectiveness lag
      • There is a time lag between the implementation of fiscal policies to seeing the actual effects take place in the economy
      • A small reduction in income tax will take time to have a significant impact on household consumption
      • The construction of a new school will take many years before graduates enter the labor force
  • Sustainable debt
    • The effectiveness of fiscal policy will depend on the extent to which the government can afford to sustain a budget deficit
    • In the short run, governments may be able to run budget deficits in order to fund expansionary fiscal policies
    • However, this is not sustainable in the long run. Ultimately, the government will need to implement austerity measures to repay its national debts, limiting the effectiveness of fiscal policy
  • Crowding out
    • When a government runs a budget deficit, it needs to borrow funds (issueing/selling bonds)
    • Crowding out occurs when increased government borrowing causes interest rates to rise owing to the higher demand for loanable funds (D_money1→D_money2 ).
    • Overall, this causes a reduction in private sector investment expenditure due to the higher costs of borrowing (𝑖_1→𝑖_2 )

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