FACULTY OF COMMERCE

DEPARTMENT OF FINANCE GROUP2

Student name student number

Tinotenda kademeteme : N02127200T
Alistair Hurumidza : N02160005H
Christabel Moyo : N02126725Y
Melokhuhle Mpofu : N02125892V
Thubalenkosi Magonya : N02123675X
Tonie Kwedza : N021232903V
What is fiscal policy? Show your understanding of Contractionary fiscal policy and expansionary fiscal
policy.

Fiscal policy is the use of taxation and government spending as a tool for influencing level of AD in
the economy

 Government spending has powerful effects on the the level of economic activity in a nation
 An increase or decrease in level of government spending on goods and services, overall
demand can be indirectly influenced through fiscal policy.
 Fiscal policy is used by government to manage overall level of economic activity of a nation.
 By changing level of government spending and taxation this can influence AD either by
stimulating it during recession or contracting during inflation in order to promote the
macroeconomic objectives.

Government budget concept

The government must finance its expenditures through the collection of taxes from households and
firms ,through borrowing from the public ,or through the sale of state owned prices to the private
sector. Projected expenditures show what the government will spend on which can be public goods
and services ,infrastructure health, education and defense

EXPANSIONARY FISCAL POLICY

It is a decrease in taxation and an increase in government spending aimed at increasing the level of
AD to close a recessionary gap and move an economy towards its full employment level of output.

Expansionary fiscal policy is a fiscal policy normally employed during a recession. Recession being a
significant decline in economic activity or can be defined as a time of falling Aggregate demand. The
government uses expansionary fiscal policy to increase the level of economic activity and increase
employment
 How does increasing government spending lead to an increase in AD

 Government spending is a direct component of Ad

 Increase government spending directly injects money into the circular of income and
causes an increase in AD and output

 Government may increase its spending by creating employment and through direct
provision as well for example government may engage in manufacturing of
foodstuffs .Employment creation leads to an increase income .When people have
more income they tend to demand more thereby increasing AD.

 Through direct provision of subsidizing it leads to increased production which is

likely to result in lower prices .As prices of goods fall quantity demanded increases.
Subsidies lowers cost of production thereby lowering price of commodities thereby
increasing demand.

Tax cuts
 Tax cuts lower cost of production and shift AD outwards from AD to AD 1 helping
economy reach full employment
 During a recession government may attempt to bridge the reduction in demand by
giving a windfall to citizens via a tax cut or an increase in government
spending .This creates jobs and alleviates unemployment
 A decrease in tax will lead to an increase in disposable income so if firms enjoy more
profits because they are paying fewer taxes firms are most likely to invest in
equipment and technology
 An example of tax cuts as expansionary fiscal policy is the economic stimulus act
2008,in which the government attempted to boost the economy by sending tax
payers $600 or $1200 depending on their marital status and number of dependants
and total cost was $152 billion

Advantages
 It can have a rapid impact if implemented correctly
 Government spending can create jobs and lessen unemployment
 Tax cuts can put money directly into tax payer pockets meaning when tax is reduced
the ones who actually bear the burden of tax are left with more disposable income.

Disadvantages

 Tax cuts diminish government revenue ,which can result in growing national debt,
erosion of public confidence and rising interest rates
  The tax cuts used to improve economic conditions must be reversed later to restore
revenue and pay down the national debt.
 Government may use expansionary fiscal policy for their own ends

CONTRACTIONARY FISCAL POLICY

A government macroeconomic policy that involves cutting public expenditure and/or increasing total
taxation to reduce aggregate demand if an economy is overheating with the general level of prices
rising rapidly.

Now looking at a situation in which a country has an inflationary gap and output is beyond full
employment this economy is overheating and has inflation that is higher than desirable and its price
level PL1 is greater than full employment so this country’s economy is overheating so what it needs
is the contractionary fiscal policy.

This could be a result of depreciation of countries currency which has led to an unexpected increase
in Net exports or it could be a decrease in interest rates resulting in businesses to invest more

If unemployment rate is low and there is no slack in the labour market. There is no possible way for
economy to continue growing without inflation getting out of control

If left this economy would enter a recession accompanied by inflation

So government uses Contractionary fiscal policy

An increase in tax will result in a fall in disposable and a fall in consumption and a fall in investment

This will lead to a decrease in AD and price level which will bring back down national income

 On contractionary fiscal policy government taxes more than it spends either by increasing
tax rates, decreasing spending or both.

A reduction in government spending will result in a fall in aggregate demand, fall in price level
and income thereby achieving macroeconomic objective of lowering inflation, full employment,
stable economic growth

Purpose

 Contractionary fiscal policy is used in times of economic prosperity because it slows down
inflation.
 During times of high economic growth ,inflation can increase
 To slow down inflation government may use CFP to decrease money supply and Ad
 When economy is booming government may make use of CFP in order to reduce the
government’s budget deficit and national debt, saving money for future
 Paces economic growth
 Keeps unemployment at optimal levels

18) With the aid of examples clearly distinguish between discretionary fiscal policy and automatic

Fiscal policy (automatic stabilisers in fiscal policy).

Discretionary fiscal policy

On occasions government will intervene in the economy for specific purposes, such as reinforcing
the built in stabilisers already described.

 If the economy is tending to expand too rapidly, so that inflationary pressures are building
up, then the government may seek to reduce its spending (G) OR raise taxes (T)
  Conversely, if the economy is slowing down, so that unemployment is rising and output
failing, than the government may seek to raise its spending (G) or reduce taxes (T) to
stimulate the economy.

These are examples of discretionary fiscal policy, where the government makes a conscious decision
to change its spending or taxation policy .As compared to built in stabilisers, discretionary fiscal
stabilisation policy faces a number of difficulties involving time lags i.e

 It takes time for the government to collect and analyse data, recognise any problems that may
exist and then decide what government spending and taxation decisions to takes (recognition
lag)

 Having made its fiscal policy decisions it takes time to implement these changes and it also
takes time for these changes to have an effect to the economy. ( Execution lag)

In terms of discretionary fiscal policy these time lags can result in the government reinforcing the
economic cycle, rather stabilising it as indicated below

Discresionary fiscal policy is shown as a dotted line ( 2 period lag ) in the diagram

 Where the economic cycle is experiencing an inflationary gap ( time period 1 and 2 ) the
appropriate discretionary policy is a bugdet surplus ( G<T) .

 Where the economic cycle is experiencing an defllationary gap ( time period 3 and 4 ) the
appropriate discretionary policy is a bugdet deficit ( G>T) .

To sum up , if the timing of the discretionary fiscal policy is correct, , then intervention by the
government will help to stabilise the economic cycle.
Automatic Fiscal policy (automatic stabilisers in fiscal policy).

During economic fluctuation i.e. recession or boom, there are changes in the government spending
and taxation which happen automatically. Also can be defines as built stabilisers which help to
soften the impact of the recession economic boom

Take for instance a Us government issue a COVID-19 unemployment benefit and South Africa issued
50 rand grants as soon as covid 19 started

So the intention was to improve standards of living but on the other hand it automatically reduced
the recession or the decrease in Aggregate demand that was going to occur.

Automatic fiscal policy is built in to a nation’s gvt budget as show below ….

When the economy in equilibrium at full employment (yfe),there efficient in the economy ie nearly
everyone who needs a job has a job .Now lets assume that since the economy is efficient there is a
balanced budget ( government revenue collection is equal to government spending on Transfer
payment e.g. unemployment benefits , subsidies etc.)

Now, when there is a fall in aggregate demand due to unemployment , shifting aggregate demand
the left . As a result of this economic recession ,national income is going to fall to Y1 and also
deflation as the price level falls to PL1

With that said , what will happen automatically, is when there is a recession , Taxation is going to
reduce (less taxes are collected ), that is, there is an a decrease in income income tax
revenues reduces , decrease in consumption leads to a decrease in VAT revenue and a fall in profits
is directly proportional to corporation tax.

On the other hand, there will be increase in spending on transfer payments by the government, ie
unemployment benefits , welfare benefit , subsidies , payments but the government in order to
boost aggregate demand.

The government will automatically slip into a budget deficit as its spending on transfers is greater
than its revenues collection ( taxation)
 These factors combined mean that AD is increased slightly to AD 2 , therefore reducing the
volatility of GDP and reducing the height of the recession

Reduction in AD = increase in government spending ie increased unemployment benefit,

subsides, welfare benefit

On the flip side of then coin, when there is a positive demand shock or a demand pull inflation ,
Aggregate demand shifts to the right , National income increases to Y2 followed by inflation …. Price
level increases to PL2 , now the economy is over heating maybe due to excessive consumption ,
investments etc…

These effect of automatic stabilisers as GDP increases are

Tax revenue automatically increases , firms are earning high profits, household are also raning high
incomes , consumption increases which leads to an rise taxation( gvt revenue collection )

At the same time , government spending of transfer payments is reduced , less people are
unemployed , production is effective therefore the amount spent on subsidies falls.

As a result government revenue collection (taxation) is greater than its spending on transfer
payment therefore there is a budget surplus which is a contractionary policy , then AD is reduced
slightly to AD3 , reducing the volatility of GDP and reducing the height of the boom , ie there wil be
less inflation , the economy will not be overheating by as much as it would have without these built
in stabilizers
To sum up , for discretionary fiscal policy there is a time lag as the government may take time to
decide on which policies to implement . On the other hand, there are built in stabilisers which help
to soften then changes in output when there are fluctuations in the economy .