Evaluating the impact of fiscal policy on output, employment, prices and agents

Overview

How an expansionary fiscal policy affects employment, expansionary fiscal policy risk demand-pull inflation and how a contractionary fiscal policy affects firms.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Analyse how an expansionary fiscal policy affects employment.

   Model answer

   Higher government spending or lower taxation raises aggregate demand, so firms sell more output and need more labour to produce it. Because the demand for labour is derived from the demand for the goods labour produces, employment rises and cyclical unemployment falls, which in turn raises household incomes and supports a further round of consumer spending. The size of the employment gain depends on how much spare capacity exists, on whether firms respond by hiring rather than by working existing staff harder, and on whether the unemployed have the skills the expanding sectors need.

2. 2

   Why does an expansionary fiscal policy risk demand-pull inflation?

   Model answer

   The policy increases total planned spending in the economy, but the ability of firms to produce more is limited by the labour, capital and materials available. As spare capacity is used up, firms competing for the same scarce resources bid up wages and input prices and pass those costs into selling prices, so the general price level rises. The closer the economy starts to full capacity, the greater the share of the stimulus that shows up as inflation rather than as extra output.

3. 3

   Who gains and who loses among economic agents when a government raises spending on public services and funds it with a higher top rate of income tax?

   Model answer

   Users of the expanded services gain, particularly lower-income households who rely more heavily on state provision, and public sector workers gain from stronger job security and possibly higher pay. Firms supplying the public sector gain from larger contracts, and unemployed workers gain if the extra demand creates jobs. High earners lose disposable income, may reduce hours or seek to shelter income, and savers may lose out if the extra demand pushes up inflation and erodes the real value of their money holdings.

4. 4

   Evaluate whether a government seeking to boost a weak economy should cut taxes or increase its own spending.

   Model answer

   Spending increases have a more certain effect on demand because every pound is spent on domestic output, and if directed at infrastructure or training they also raise future capacity, but they take time to design and deliver and can be hard to reverse once services and staffing have expanded. Tax cuts can be implemented quickly and leave the choice of what to buy with households and firms, which avoids government misallocating resources, but part of the money will be saved or spent on imports so the demand effect is weaker and less predictable. The right choice depends on how urgently demand is needed, on how confident households are, and on whether the government also wants a lasting supply-side gain, with a strong case for capital spending when confidence is low and for tax cuts when speed matters most.

5. 5

   Why does the effectiveness of a fiscal stimulus depend on the size of the output gap?

   Model answer

   The output gap measures the difference between actual output and the economy’s productive capacity. With a large negative gap there are unemployed workers and idle machines, so extra demand can be met by raising production and most of the stimulus shows up as real output and jobs. With a positive gap the economy is already stretched, so extra demand simply bids up wages and prices and the stimulus is largely dissipated in inflation, which is why the same policy can be sensible in one year and harmful in another.

6. 6

   Why do leakages weaken the impact of a fiscal stimulus on domestic output?

   Model answer

   Not all of the money injected stays in the domestic circular flow. Part of any rise in income is saved rather than spent, part returns to the government as tax on the extra income and spending, and part is spent on imported goods and so becomes income for foreign producers. The larger these withdrawals are, the smaller the eventual rise in domestic output, which is why an open economy with a high share of income spent on imports gets less domestic benefit from a given stimulus than a more closed one.

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