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    Expansionary (Or Loose) Fiscal Policy

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    Faisal Hameed
    Fiscal policy involves governments using spending and taxation to influence economic activity. Governments can pursue expansionary fiscal policy by increasing spending and reducing taxes to stimulate aggregate demand during recessions. They can pursue contractionary fiscal policy by reducing spending and raising taxes to decrease aggregate demand and control inflation. However, fiscal policy faces criticisms such as time lags and the potential for government spending to crowd out private sector activity.

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    Expansionary (Or Loose) Fiscal Policy

    Uploaded by

    Faisal Hameed
    70 views4 pages
    Fiscal policy involves governments using spending and taxation to influence economic activity. Governments can pursue expansionary fiscal policy by increasing spending and reducing taxes to stimulate aggregate demand during recessions. They can pursue contractionary fiscal policy by reducing spending and raising taxes to decrease aggregate demand and control inflation. However, fiscal policy faces criticisms such as time lags and the potential for government spending to crowd out private sector activity.

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    Fiscal Policy

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    Fiscal policy involves governments using spending and taxation to influence economic activity. Governments can pursue expansionary fiscal policy by increasing spending and reducing taxes to stimulate aggregate demand during recessions. They can pursue contractionary fiscal policy by reducing spending and raising taxes to decrease aggregate demand and control inflation. However, fiscal policy faces criticisms such as time lags and the potential for government spending to crowd out private sector activity.

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    70 views4 pages

    Expansionary (Or Loose) Fiscal Policy

    Uploaded by

    Faisal Hameed
    Fiscal policy involves governments using spending and taxation to influence economic activity. Governments can pursue expansionary fiscal policy by increasing spending and reducing taxes to stimulate aggregate demand during recessions. They can pursue contractionary fiscal policy by reducing spending and raising taxes to decrease aggregate demand and control inflation. However, fiscal policy faces criticisms such as time lags and the potential for government spending to crowd out private sector activity.

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    Fiscal Policy

    Definition of fiscal policy. Fiscal policy involves the government changing the levels of
    taxation and government spending in order to influence Aggregate Demand (AD) and the
    level of economic activity.

     AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)

    The purpose of Fiscal Policy

     Stimulate economic growth in a period of a recession.


     Keep inflation low (UK government has a target of 2%)
     Fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic cycle.

    Fiscal policy is often used in conjunction with monetary policy. In fact, governments often
    prefer monetary policy for stabilising the economy.

    Expansionary (or loose) Fiscal Policy


     This involves increasing AD.
     Therefore the government will increase spending (G) and cut taxes (T). Lower taxes will increase
    consumers spending because they have more disposable income (C)
     This will tend to worsen the government budget deficit, and the government will need to increase
    borrowing.

    Diagram showing effect of expansionary fiscal policy

    Deflationary (or tight) Fiscal Policy


     This involves decreasing AD.
     Therefore the government will cut government spending (G) and/or increase taxes. Higher taxes
    will reduce consumer spending (C)
     Tight fiscal policy will tend to cause an improvement in the government budget deficit.

    Diagram showing the effect of tight fiscal policy

    UK fiscal policy

    UK Budget deficit

    In 2009, the government pursued expansionary fiscal policy. In response to a deep


    recession (GDP fell 6%) the government cut VAT in a bid to boost consumer spending.
    This caused a big rise in government borrowing (2009-10). (Government borrowing also
    rose because of the recession leading to lower tax revenue)

    When the new coalition government came into power in May 2010, they argued the
    deficit was too high and then announced plans to reduce government borrowing. This
    involved spending limits. These austerity measures were a factor in causing lower
    economic growth in 2011 and 2012.

    Terms relating to fiscal policy


     Fiscal Stance: This refers to whether the government is increasing AD or decreasing AD, e.g.
    expansionary or tight fiscal policy
     Fine Tuning: This involves maintaining a steady rate of economic growth through using fiscal
    policy. However, this has proved quite difficult to achieve precisely.
     Automatic fiscal stabilisers – If the economy is growing, people will automatically pay more
    taxes ( VAT and Income tax) and the Government will spend less on unemployment benefits.
    The increased T and lower G will act as a check on AD. But, in a recession, the opposite will
    occur with tax revenue falling but increased government spending on benefits, this will help
    increase AD
     Discretionary fiscal stabilisers – This is a deliberate attempt by the government to affect AD
    and stabilise the economy, e.g. in a boom the government will increase taxes to reduce inflation.
     The multiplier effect. When an increase in injections causes a bigger final increase in Real GDP.

     Injections (J) – This is an increase of expenditure in the circular flow, it includes govt
    spending(G), Exports (X) and Investment (I)
     Withdrawals (W) – This is leakages from the circular flow This is household income that is not
    spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M)

    Criticism of fiscal policy


    1. The government may have poor information about the state of the economy and struggle to have
    the best information about what the economy needs.
    2. Time lags. To increase government spending will take time. It could take several months for a
    government decision to filter through into the economy and actually affect AD. By then it may be
    too late.
    3. Crowding out. Some economists argue that expansionary fiscal policy (higher government
    spending) will not increase AD because the higher government spending will crowd out the
    private sector. This is because the government have to borrow from the private sector who will
    then have lower funds for private investment.
    4. Government spending is inefficient. Free market economists argue that higher government
    spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to
    reduce spending in the future because interest groups put political pressure on maintaining
    stimulus spending as permanent.
    5. Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to higher
    bond yields, increasing the cost of debt repayments.

     Criticisms of Fiscal Policy – More detail on criticisms of fiscal policy

    Evaluation of fiscal policy


    The success of fiscal policy will depend on several factors, such as
    1. It depends on the size of the multiplier. If the multiplier effect is large, then changes in
    government spending will have a bigger effect on overall demand.
    2. It depends on the state of the economy. Fiscal policy is most effective in a deep recession where
    monetary policy is insufficient to boost demand. In a deep recession (liquidity trap). Higher
    government spending will not cause crowding out because the private sector saving has
    increased substantially. See: Liquidity trap and fiscal policy – why fiscal policy is more important
    during a liquidity trap.
    3. It depends on other factors in the economy. For example, if the government pursue expansionary
    fiscal policy, but interest rates rise, and the global economy is in a recession, it may be
    insufficient to boost demand.
    4. Bond yields. If there is concern over the state of government finances, the government may not
    be able to borrow to finance fiscal policy. Countries in the Eurozone experienced this problem in
    the 2008-13 recession.

    Brief history of fiscal policy

     Keynes advocated the use of fiscal policy as a way to stimulate economies during the great
    depression.
     Fiscal Policy was particularly used in the 50s and 60s to stabilise economic cycles. These
    policies were broadly referred to as ‘Keynesian’
     In the 1970s and 80s governments tended to prefer monetary policy for influencing the economy.
    Fiscal policy became more prominent during the great depression of 2008-13

    US fiscal policy

    Evaluation of US expansionary fiscal policy in 2009

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