Fiscal policy
Key terms
Define each term.
Multiple choice
Circle the correct answer.
A government cuts income tax rates and raises spending on infrastructure. This is best described as:
Which statement correctly distinguishes a budget deficit from the national debt?
During a recession a country's budget deficit widens even though the government has announced no change to tax rates or spending plans. The most likely explanation is:
Worked problems
Show your working.
Classifying a tax system from its bands. A country taxes income at 0% on the first $10,000, 20% on income between $10,001 and $50,000, and 32% on income above $50,000. Calculate the average and marginal rates of tax for a worker earning $60,000 and state whether the system is progressive.
Calculating the multiplier and the change in national income. In an open economy the marginal propensity to save is 0.15, the marginal rate of tax is 0.20 and the marginal propensity to import is 0.05. The government increases spending by $40 billion. Calculate the multiplier and the resulting change in national income, then state what happens to your answer if the marginal propensity to import doubles.
Chains of reasoning
The steps are in the wrong order. Write the letters in the order that makes a linked chain.
How expansionary fiscal policy reduces demand-deficient unemployment
- A Firms respond to higher orders by raising output, since inventories are being run down.
- B Higher disposable income raises consumption C, since some proportion of any extra income is spent rather than saved.
- C The government raises spending on infrastructure and cuts the basic rate of income tax.
- D Aggregate demand shifts right, because both G and C are components of AD.
- E The initial spending becomes income for construction workers and suppliers, who spend a share of it in turn, so the final rise in national income exceeds the initial injection.
- F Government spending G rises directly, and lower income tax raises households' disposable income.
- G Employment rises and demand-deficient unemployment falls, while real GDP increases.
- H Labour is a derived demand, so producing more output requires employing more workers.
Crowding out: how a fiscal expansion can cancel itself
- A The government raises spending without raising taxes, so it must finance the gap by borrowing.
- B The effective multiplier is smaller than the arithmetic multiplier suggests, and in the extreme case of full crowding out, national income does not rise at all.
- C It issues bonds, which increases the demand for loanable funds in the financial market.
- D Private sector investment I therefore falls, and interest-sensitive consumption such as mortgage-financed housing falls with it.
- E With the supply of loanable funds given in the short run, the increased demand raises the market rate of interest.
- F The rise in G is partly or wholly offset by the fall in I and C, so aggregate demand shifts right by less than the initial injection.
- G Investment is inversely related to the rate of interest, since a higher rate means fewer projects clear their hurdle rate of return.
Diagrams
Draw a circular flow of income diagram for an economy with a government sector. Label the flows between households and firms, then add taxation as a withdrawal and government spending as an injection. Mark clearly which arrow the government controls in each case.
Draw an AD/AS diagram showing an economy operating below full employment. Show the effect of expansionary fiscal policy, labelling the shift of AD, the change in real output and the change in the price level. Then repeat the shift on a diagram where AS is near-vertical.
Extended answer
Plan your answer: list the points you would make in each paragraph.
Assess whether fiscal policy is the most effective means of achieving the macroeconomic objective of full employment. (13 marks)
Answers
Fiscal policy: The use of government spending and taxation to influence the level of economic activity and to achieve macroeconomic aims.
B. Both measures increase total demand, and both operate through the government budget rather than through interest rates or the money supply. Infrastructure spending also has supply-side effects over the long run, but the immediate classification is expansionary fiscal policy.
B. The deficit is a flow, measured over a period, and the debt is a stock, measured at a moment. A government can reduce its deficit every year and still see its national debt rise, because any deficit at all adds to the accumulated total.
B. With rates and plans unchanged, the movement is not discretionary. Falling incomes reduce income tax and expenditure tax receipts while rising unemployment increases benefit payments, so the deficit widens by itself. This is the stabiliser working as intended, cushioning the fall in disposable income and therefore in aggregate demand.
Step 1. Work out the tax paid on each band. First band: 0% of $10,000 = $0. Second band: 20% of ($50,000 - $10,000) = 20% of $40,000 = $8,000. Third band: 32% of ($60,000 - $50,000) = 32% of $10,000 = $3,200.
Step 2. Total the tax paid. $0 + $8,000 + $3,200 = $11,200.
Step 3. Calculate the average rate of tax. ($11,200 / $60,000) x 100 = 18.67%, or 18.7% to one decimal place.
Step 4. Identify the marginal rate of tax. The next dollar earned is taxed in the top band, so the marginal rate is 32%.
Step 5. Classify the system. The marginal rate of 32% exceeds the average rate of 18.7%, so a further dollar of income is taxed more heavily than income has been on average. The proportion of income paid in tax therefore rises with income, which is the definition of a progressive tax system.
Show the band-by-band working even when the question only asks for the final figure. Method marks are available and a single arithmetic slip then costs one mark rather than all of them.
Step 1. Find the marginal propensity to withdraw. MPW = MPS + MPT + MPM = 0.15 + 0.20 + 0.05 = 0.40.
Step 2. Calculate the multiplier. k = 1 / MPW = 1 / 0.40 = 2.5.
Step 3. Check using the consumption form. If 0.40 of each extra dollar is withdrawn then 0.60 is spent on domestic output, so MPC = 0.60. k = 1 / (1 - 0.60) = 1 / 0.40 = 2.5. The two forms agree, as they must.
Step 4. Calculate the change in national income. Change in Y = k x injection = 2.5 x $40bn = $100 billion.
Step 5. Recalculate with a higher import propensity. MPM rises from 0.05 to 0.10, so MPW = 0.15 + 0.20 + 0.10 = 0.45 and k = 1 / 0.45 = 2.22. Change in Y = 2.22 x $40bn = $88.9 billion, a fall of roughly $11 billion.
Step 6. Interpret the result. A larger share of each round of spending leaks abroad as demand for imports rather than circulating as domestic income. The more open the economy, the weaker the domestic effect of a given fiscal expansion, and the more of the stimulus accrues to trading partners.
Step 6 is where the marks separate. A candidate who produces 2.22 and stops has answered a calculation question; one who explains that openness weakens fiscal policy has produced analysis that can be carried straight into an essay.
C, F, B, D, A, H, G, E
- The government raises spending on infrastructure and cuts the basic rate of income tax.
- Government spending G rises directly, and lower income tax raises households' disposable income.
- Higher disposable income raises consumption C, since some proportion of any extra income is spent rather than saved.
- Aggregate demand shifts right, because both G and C are components of AD.
- Firms respond to higher orders by raising output, since inventories are being run down.
- Labour is a derived demand, so producing more output requires employing more workers.
- Employment rises and demand-deficient unemployment falls, while real GDP increases.
- The initial spending becomes income for construction workers and suppliers, who spend a share of it in turn, so the final rise in national income exceeds the initial injection.
AO2 analysis carries 40% of the marks, and it is the linking that earns them. The weakest version of this answer is 'the government spends more so unemployment falls'. Every arrow above is a separate creditable step.
A, C, E, G, D, F, B
- The government raises spending without raising taxes, so it must finance the gap by borrowing.
- It issues bonds, which increases the demand for loanable funds in the financial market.
- With the supply of loanable funds given in the short run, the increased demand raises the market rate of interest.
- Investment is inversely related to the rate of interest, since a higher rate means fewer projects clear their hurdle rate of return.
- Private sector investment I therefore falls, and interest-sensitive consumption such as mortgage-financed housing falls with it.
- The rise in G is partly or wholly offset by the fall in I and C, so aggregate demand shifts right by less than the initial injection.
- The effective multiplier is smaller than the arithmetic multiplier suggests, and in the extreme case of full crowding out, national income does not rise at all.
The counter-argument is as important as the chain itself. Crowding out requires the supply of loanable funds to be constrained. In a recession with idle savings and a central bank holding rates near the lower bound, the mechanism is weak, and government borrowing may crowd in private investment by raising expected demand. Set out the chain, then state the condition under which it bites.
The purpose of drawing it is to see why the two levers pull in opposite directions. Taxation takes money out of the flow, so raising it reduces the income circulating. Government spending puts money in, so raising it increases the income circulating. A budget deficit means injections from the government exceed withdrawals, which is why an unbalanced budget in that direction expands the economy.
The point of drawing it twice is the comparison. On the elastic section of AS most of the shift becomes extra real output with little price rise. Near full capacity the same shift is absorbed almost entirely by a higher price level, so the policy delivers inflation instead of growth. Examiners reward candidates who make the outcome depend on where the economy currently sits rather than assuming the convenient case.
Define and frame: Define fiscal policy and full employment, and distinguish demand-deficient unemployment from structural and frictional unemployment. State the criterion for effectiveness up front: fiscal policy can only address the demand-deficient component, so the answer turns partly on which type of unemployment the economy actually has. Flag that effectiveness will be judged against monetary and supply-side alternatives.
Analysis: the case for: Run the transmission chain from G and C through AD to derived demand for labour, supported by an AD/AS diagram on the elastic section of AS. Add the multiplier, quantifying it if data are given. Note that government spending is a direct injection and does not depend on the private sector choosing to respond, which is its key advantage over monetary policy when confidence is weak.
Analysis: the alternatives: Treat both alternatives seriously. Monetary policy acts faster, has shorter recognition and implementation lags, and can be reversed quickly, though it is ineffective at the lower bound and relies on interest-sensitive spending responding. Supply-side policy is the only instrument that addresses structural unemployment, through retraining and improved labour mobility, but it works over years rather than quarters.
Evaluation: Weigh the limitations against each other rather than listing them. Crowding out matters when loanable funds are constrained and barely at all in a slump, so its force depends on the state of the economy. Time lags may deliver the stimulus into a recovery. The multiplier is smaller in an open economy and smaller again when confidence is weak. There is an opportunity cost in higher borrowing and future debt servicing, and a conflict with the inflation objective as the economy nears capacity. Against all this, weigh the fact that fiscal policy is the only instrument that works when interest rates cannot fall further.
Judgement: Reach a conclusion conditional on stated circumstances. Fiscal policy is most effective where unemployment is demand-deficient, spare capacity is substantial, the economy is relatively closed and monetary policy is constrained. It is least effective where unemployment is structural, capacity is tight, or the economy is small and open. The strongest conclusions argue for a combination, with fiscal policy supplying demand in the short run and supply-side measures addressing the structural component, and specify which conditions make that combination necessary.