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

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.

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

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.

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

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.

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

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.

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

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.

CCEA AS-Level Economics 4410

Key Economic Concepts

Topic overview The four factors of production Positive statements and normative judgements Economic agents and what they are trying to achieve Capital goods and consumption goods Product markets and factor markets

The Basic Economic Problem of Scarcity and Choice

Topic overview Scarcity, choice and opportunity cost Drawing and reading the production possibility frontier Using a PPF to show choice, opportunity cost, efficiency and growth Why an economy operates inside its frontier Specialisation and the division of labour Free market, planned and mixed economies

Demand and Supply in Product Markets

Topic overview What determines demand and what determines supply Movements along a curve versus shifts of a curve Why the demand curve slopes downwards Why the supply curve slopes upwards: marginal cost and the profit incentive Consumer surplus and producer surplus When consumers do not behave rationally

Markets and Equilibrium

Topic overview Market equilibrium and how markets clear How shifts in demand and supply change the equilibrium Price signals, incentives, rationing and the role of profit Joint, composite and derived demand and joint supply Tracing effects between interrelated markets Community surplus and allocative efficiency Demand and supply in housing, energy and commodity markets Indirect taxes and subsidies: impact and incidence

Elasticity of Demand and Supply

Topic overview Price elasticity of demand: measuring and interpreting Income and cross elasticity: normal, inferior, substitutes and complements Price elasticity of supply What determines the value of an elasticity Elasticity and total revenue How useful is elasticity for firms and government?

Factor Markets: Labour

Topic overview How a competitive labour market sets the wage Elasticity of labour demand and labour supply Wage differentials and why they persist Economic rent and transfer earnings Flexibility: trade unions, welfare and migration Minimum wages and government intervention in the labour market

Market Failures and Imperfections

Topic overview Market equilibrium, the social optimum and the meaning of market failure Externalities: private, external and social costs and benefits Community surplus and the externality diagrams Calculating and interpreting welfare loss Public goods, quasi-public goods and the free rider problem The consequences of missing markets for public goods Merit goods and demerit goods Information gaps and asymmetric information The consequences of merit goods, demerit goods and information failure Market power and other market imperfections Income and wealth inequality Absolute and relative poverty

Government Intervention in Markets

Topic overview Why governments step into markets Indirect taxes Subsidies, and choosing between taxes and subsidies Maximum and minimum prices State provision Regulation Information provision Tradeable pollution permits Government failure

The Circular Flow of Income

Topic overview Households, firms and the two-way flow Injections and withdrawals in an open economy with government Equilibrium and change in the circular flow

Measuring National Income

Topic overview Three routes to the same total: income, expenditure and output GDP as a measure of welfare and its limitations Domestic or national? GDP and GNP compared Nominal and real values: correcting for price changes Total and per capita measures

Aggregate Demand

Topic overview The four components of aggregate demand Why the aggregate demand curve slopes downwards Movements along and shifts in aggregate demand Factors that shift aggregate demand Investment: gross, net and fixed capital

Aggregate Supply

Topic overview Why short-run aggregate supply slopes upwards Factors that shift short-run aggregate supply Movements along and shifts in aggregate supply From the short run to the long run What determines long-run aggregate supply Keynesian and neoclassical views of long-run aggregate supply

Macroeconomic Equilibrium

Topic overview How aggregate demand and aggregate supply determine equilibrium Applying AD-AS analysis to growth and unemployment Applying AD-AS analysis to inflation

Macroeconomic Objectives

Topic overview Why governments target inflation, unemployment, the external balance and growth Objectives beyond the main four: the environment and the distribution of income and wealth Picturing inequality: the Lorenz curve and the Gini coefficient Where the objectives collide: the main policy conflicts Judging the trade-offs: how sharp is a conflict?

Inflation

Topic overview Inflation, deflation and disinflation: what the words actually mean Measuring the rate: the CPI and the RPI Working with index numbers Building a price index: the basket and the significance of weights Demand-pull and cost-push inflation The costs and consequences of inflation and deflation The policy response to inflation

Unemployment

Topic overview The claimant count and the ILO measure of unemployment Calculating and interpreting unemployment statistics Unemployment and economic inactivity: a distinction that changes the numbers The types of unemployment and what distinguishes them The causes of unemployment and of economic inactivity The costs and consequences of unemployment and inactivity Policies for unemployment and intervention in the labour market

Economic Growth

Topic overview Actual and potential growth on a production possibility frontier Measuring economic growth The economic cycle and output gaps The causes of economic growth Benefits, costs and the sustainability of growth Policies to promote economic growth using AD–AS analysis

Fiscal Policy and Its Effects

Topic overview What fiscal policy is and how it works Government spending and taxation: the main categories Direct and indirect taxation Fiscal policy in the AD-AS model Evaluating the impact of fiscal policy on output, employment, prices and agents

Monetary Policy

Topic overview The nature of monetary policy and the interest rate instrument The transmission mechanism from interest rates to aggregate demand Monetary policy in the AD-AS model Evaluating the impact of monetary policy on output, employment, prices and agents

Supply-Side Policies

Topic overview The nature of supply-side policy and tax cuts Deregulation and evaluating market-based supply-side policy Competition and innovation as supply-side policy Infrastructure as supply-side policy Labour market reform Education, training and the skills of the workforce Labour productivity: determinants and significance Supply-side policies in the AD-AS model Evaluating the impact of supply-side policies

Exchange Rates and the National Economy

Topic overview What an exchange rate is and how it is measured Exchange rate changes in the AD-AS model Holding the exchange rate above or below the market clearing level Why a government might have an exchange rate policy Evaluating the impact of exchange rate changes on output, employment, prices and agents

Quantitative Skills in Economics

Topic overview Ratios, shares and proportions in economic data Percentages and percentage changes in economic data Averages, medians and quantiles Index numbers, weighting and rebasing Converting money values to real values Cost, revenue and profit Elasticity: calculating the number and reading its meaning Choosing and reading economic charts and diagrams Interpreting economic data critically

Fiscal Policy and Its Effects

5 subtopics
9 things to know
Unit AS 2

What Fiscal Policy and Its Effects covers

Fiscal policy and its effects is examined in Unit AS 2, Managing the National Economy. It covers what fiscal policy is and how it works, government spending and taxation: the main categories, direct and indirect taxation, fiscal policy in the AD-AS model and evaluating the impact of fiscal policy on output, employment, prices and agents.

Where it is assessed

Unit AS 2

Managing the National Economy, written examination, 20% of A level.

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The 5 subtopics

Each one has its own page. CCEA AS Economics students sit this topic in the first year.

What you need to know

Answer each one before you reveal it.

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Key term

What is fiscal policy, and which instruments does a government use to operate it?

Key term

Which are the largest areas of government spending in a typical advanced economy, and what does each cover?

Key term

What are the main sources of government tax revenue?

Key term

Why does a government seeking reliable revenue tend to tax goods with inelastic demand?

Key term

Why is the ability to shift the burden the key distinction between direct and indirect taxes?

Key term

Corporation tax is a direct tax on company profits. Explain how a cut in it might affect investment, and why the effect is uncertain.

Key term

In the aggregate demand and aggregate supply model, what is measured on each axis and what does each curve show?

Key term

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

Key term

Analyse how a contractionary fiscal policy affects firms.

Take Fiscal Policy and Its Effects further

The same content, four other ways.

Questions from this topic

Each one with the model answer underneath.

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
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
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
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
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
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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Key Economic Concepts

The Basic Economic Problem of Scarcity and Choice

Demand and Supply in Product Markets

Markets and Equilibrium

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AThe initial spending becomes income for those who receive it.

BPart of that income is spent again, generating further income.

CThe total effect on demand exceeds the original injection.

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