• FISCAL POLICY is called a 'DEMAND-SIDE POLICY' because it is aimed at influencing the level of AGGREGATE DEMAND in the economy, SHIFTING the AD curve either to the left or to the right.

• A government budget is a document that outlines a government's PROJECTED REVENUES and PLANNED SPENDING for a fiscal year

"Can you run a surplus and still be in debt?"

• When you borrow money, you are said to be 'IN DEBT' and you are expected to pay back installments that include an interest payment, and when you make your repayments, you lower this debt; you pay money to reduce it, or you can increase it by borrowing more.

• NATIONAL/GOVERNMENT DEBT refers to the DEBT that a government has accumulated through its BORROWING TO FINANCE its overspending.

  • • • • BUDGET DEFICITS are only possible via MORE BORROWING which leads to an INCREASE IN GOV'T DEBT

        • BUDGET SURPLUSES gives the government a chance to REPAY PART OF THE DEBT leading to a DECREASE IN GOV'T DEBT.

Explain how expansionary fiscal policy could be used to close a deflationary (recessionary) gap (10)

• Firstly it takes some time RECOGNISE THE PROBLEM. ('RECOGNITION LAG')

• Secondly, it will take time to decide THE APPROPRIATE POLICIES 

• And finally, the POLICIES WILL TAKE TIME TO TAKE EFFECT, especially if it's related to tax changes, which are reliant on the unpredictable nature of consumer and business confidence. ('ADMINISTRATION LAG')

• If the time lag is severe then the actual impact on AD may occur once the economy has already self-corrected, thus creating a problem it was designed to fix. 

Governments can not easily cut spending for many of their committed social services such as health care and education as well as public goods such as defense. furthermore, tax increases are politically unpopular and may be avoided by the government even though they might be necessary. Tax decreases could also be inappropriately enacted because they are politically popular. The upshot is that political factors may sometimes lead to unsuitable fiscal policies.

Much like for an individual with heavy debt, it is not really a good idea for a government that is already facing a large deficit to increase this debt in order to fund a greater level of government spending, as to do so would not only burden the economy with massive interest repayments which take away valuable revenue for other expenditures but also increase the risk of default.

In a recessionary phase, a cut in income and profit taxes, won't necessarily lead to a greater level of spending, as both consumer and business confidence is low and both parties may prefer to save their extra disposable income.

• FINE TUNING, in this context, refers to getting the economy back to the full-employment level of output, however, the precise impact of more spending and tax cuts on aggregate demand are extremely difficult to gauge, and therefore fiscal policy is seen as a tool that can get the economy moving in the desired direction, but which has a very unpredictable resting place.

• Due to 'TIME LAGS' & 'INABILITY TO FINE TUNE', if the impact of the policies only takes effect after a long period of time, then if that period is already expansionary, then any demand-side policy will only succeed in causing the price level to rise.

If contractionary policy involves REDUCING GOVERNMENT SPENDING on MERIT GOODS such as EDUCATION & HEALTHCARE as well as INFRASTRUCTURE PROJECTS such as new roads, and airports, then this can have a serious impact on the potential growth of the economy.

• Does anyone really want to consume more when they are worried about their job and their income? Does any firm want to expand when their potential customer base are all reducing their spending? The answer is "NO". As mentioned earlier, the Great Depression of the 1930s, showed how wage and price inflexibility can prevent an economy from self-correcting in a recession, as such the strength of fiscal policy and government spending in particular, is that it can 'kick-start' a stagnant economy and prevent a long drawn out period of economic depression.

• Spending on infrastructure: Spending on infrastructure projects can increase the economy's long-run productive capacity by improving productivity and increasing long-run aggregate supply, which can offset inflationary pressures. 

• Spending during a recession: If the economy is in a recession and has a significant output gap, government spending can increase aggregate demand without causing significant inflation, as there is plenty of idle capacity and labor. 

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Government spending is able to be directed at specific industries and groups which they deem the most in need or the most appropriate or leading the economy out of a recession, for example, specific infrastructure projects, merit good, and public good provision etc...

The CONTRACTIONARY effects of HIGHER TAXES should reduce both consumer and business demand, lowering the 'C' and 'I' components of AD. This fall in AGGREGATE DEMAND should put DOWNWARD pressure on the AVERAGE PRICE LEVEL.

• Spending on infrastructure projects can increase the economy's long-run productive capacity by improving productivity and increasing long-run aggregate supply, which can offset inflationary pressures. 

• In other words the increase in AD is countered by increases in LRAS, so in the long run prices remain stable.

THE KEYNESIAN MULTIPLIER refers to the SIZE of the MULTIPLE by which an initial increase in expenditure of one of the components of aggregate demand (Either C, I, G, or X), is multiplied by to arrive at the final change in REAL GDP.. 

--MULTIPLIER = CHANGE IN REAL GDP / INITIAL CHANGE IN EXPENDITURE--

QUICK QUESTION, if I was to give you a freshly printed $100, in return, for a cake you baked for me, how much do you think REAL GDP will increase by? If you thought it would be $100, then you are mistaken. This is because the spending of one person creates income for others (This is called 'INDUCED SPENDING'), who in turn spend that money and so on.... 

In our example, I printed a new $100 banknote, which was not part of my income (This is called 'AUTONOMOUS INCOME'), and the $100 I spent represented the production value of the cake, and as such GDP increased by this value after the transaction (+$100), however, that $100 created an income for the baker, who will then spend some, but not all, of that money on someone else's output, which will, in turn, be added to GDP (+$100 + $?), and this process will continue (+$100 + $? + $? +, +, ...). Therefore, the final increase in REAL GDP is much larger than the initial injection of spending which was the $100. BUT HOW MUCH BIGGER?

--HOW MUCH LARGER WILL THE INCREASE IN REAL GDP BE?-- It's tempting to suggest it will be an endless cycle of spending, however, you must remember NOT ALL INCOME IS USED FOR DOMESTIC CONSUMPTION, as some of it is deducted (WITHDRAWN/LEAKED) to pay for TAX, some of it will be SAVED, while some of it will be spent on IMPORTS.

Now If we assume that for every $ earned AFTER THE INITIAL SPEND:  

• 20% is TAXED (MARGINAL PROPENSITY TAX 'MPT')

• 10% is SAVED  ('MPS')

• 10% is SPENT ON IMPORTS  ('MPM) 

• THEREFORE, we can say 40% (20% + 10% + 10%) is WITHDRAWN ('MPW')

• 60% is SPENT ON CONSUMPTION ('MPC')

We can see WORK OUT THE MULTIPLIER...

• In pairs/or alone, imagine you are two economic advisors DISCUSSING the use of FISCAL POLICY to solve a RECESSIONARY GAP, in your discussion, one of you must be FOR its use while the other is AGAINST it. 

• First, CREATE A SCRIPT of your conversation, then act out the discussion and record the audio/video into MP4 for upload.

• Name the file: "NAME_Discuss_use_of_Fiscal_policy_in_recession.mp4" and upload to the homework site. 

• DON'T FORGET, in your script, you MUST explain the theory behind your viewpoint, and answer such questions as...

  • • • Why does fiscal policy 'automatically stabilizes' the economy?

      • Whether crowding out is a real worry?...

      • Why is a time lag a problem?

      • Why is knowledge of the multiplier important?

      • Will the multiplier effect always be fully exploited?