Fiscal Policy. Fiscal policy is the manipulation of government expenditure (G) and taxation (T) by the government to influence macroeconomic variables.
Exopansionary Fiscal Policy
An expansionary fiscal policy means government spending rises and/or taxation falls, so AD rises. Multiplier effects make AD rise further. AD shifts right so the price level rises and real GDP rises.
Contractionary Fiscal Policy
A contractionary fiscal policy means government spending falls and/or taxation rises, so AD falls. Multiplier effects make AD fall further. AD shifts left so the price level falls and real GDP falls.
Fiscal Policy influences AD through:
- Government Spending. A rise in government spending means there is more spending in the economy so AD increases.
- Income Tax. A fall in income tax means consumers’ real disposable income rises so consumption rises and AD rises.
- Corporation Tax. A fall in corporation tax means firms’ after-tax profits increase, so the profitability of investment rises, investment rises and AD rises.
Fiscal policy’s effectiveness depends on many factors:
1) Magnitude of Change in G and/or T. Fiscal policy is more (less) effective in raising AD the larger (smaller) the rise in G and/or the larger (smaller) the fall in T. A large rise in G and/or a large fall in T means AD rises a lot and shifts rightwards, the price level rises, real GDP rises and employment rises.
2) Elasticity of LRAS. Fiscal policy is more (less) effective in raising AD, real GDP and employment the more elastic (inelastic) is LRAS.
If LRAS is elastic there is a lot of spare capacity, an expansionary fiscal policy boosts AD, real GDP rises a lot, employment rises a lot but the price level rises a little bit (maybe stays the same).
If LRAS is inelastic the economy is near full capacity, an expansionary fiscal policy makes AD, real GDP and employment rise a little bit (maybe stays the same) but the price level rises a lot.
3) Short-Run vs. Long-Run. An expansionary fiscal policy increases AD, real GDP and the price level in the short-run and may increase LRAS in the long-run so the productive capacity of the economy rises, real GDP rises and the price level falls. More government spending on the infrastructure makes the economy more efficient so LRAS shifts right in the long-run. Also, as AD rises, firms’ profits rise, investment is more profitable, investment rises, more efficient machinery is developed so LRAS shifts right.
4) Time Lags. Fiscal policy takes time to come into effect due to time lags. Fiscal policy must first be announced before G and T change. Also, it takes time for the multiplier to exert its full effect.
5) Unsustainable Debt. The government cannot keep running a fiscal deficit because the government will build up debt that could become unsustainable. A level of debt too high means creditors will begin to fear that the government will default on its debt so creditors will charge the government a higher rate of interest. A higher interest rate means the government’s debt rises, the risk of default rises, credit worthiness falls, creditors charge the government higher interest rates and the spiral continues. Eventually the government must decrease government spending and increase taxation to repay the debt. AD will fall, real GDP falls and the economy falls into a recession.