What fiscal policy is and how it works

Overview

Fiscal policy and automatic stabilisers cushion the economy during a downturn.

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

   What is fiscal policy?

   Model answer

   Fiscal policy is the deliberate use of government spending and taxation to influence the level of activity in the economy. By changing how much it spends and how much it takes in tax, a government alters the total demand for goods and services and can also change the incentives faced by workers and firms. It is used to pursue objectives such as steady growth, high employment, stable prices and a fairer distribution of income.

2. 2

   Which two instruments does a government use when it operates fiscal policy?

   Model answer

   The two instruments are government spending and taxation. Spending covers everything from nurses’ salaries and school budgets to new roads and railways, while taxation covers levies on income, profits, wealth and spending. The balance between the two, and the composition of each, is what gives fiscal policy its effect.

3. 3

   What does it mean to say fiscal policy is expansionary, and give an example of each instrument being used that way?

   Model answer

   Expansionary fiscal policy means changing spending or taxation so that total demand in the economy rises. On the spending side a government might increase the budget for hospitals or launch a road-building programme; on the tax side it might cut the basic rate of income tax or reduce value added tax. Both leave more spending power flowing through the economy, so aggregate demand increases.

4. 4

   What does contractionary fiscal policy involve, and when would a government want it?

   Model answer

   Contractionary fiscal policy means cutting government spending or raising taxation so that total demand falls. A government would use it when the economy is growing faster than its productive capacity allows and demand-pull inflation is building, because reducing spending power slows the rate at which prices are being bid up. It may also be used to cool an overheating housing market or an unsustainable consumer boom.

5. 5

   Fiscal policy is usually called a demand-side policy, yet it also works on the supply side. Explain both roles.

   Model answer

   On the demand side, changes in government spending and taxation change consumption, investment and government expenditure directly, and so move aggregate demand. On the supply side, the same instruments change the productive capacity of the economy: spending on education, training and infrastructure raises the quality and mobility of resources, and cuts in taxes on income or profit alter the incentive to work, save and invest. The same measure can therefore shift both the aggregate demand curve and the aggregate supply curve, though usually over different time horizons.

6. 6

   Which components of aggregate demand does a government affect directly through fiscal policy, and which only indirectly?

   Model answer

   Government expenditure on goods and services is affected directly, because the state itself is the buyer. Consumption and investment are affected indirectly, through changes in income tax, national insurance and corporation tax that alter how much households and firms have available and how worthwhile extra activity is. Net exports may also change indirectly, since domestic demand pulls in imports and tax changes alter firms’ costs and competitiveness.

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