Topic 4 – Fiscal Policy
Refers to the governments choices regarding the overall level of government purchases or taxes
Government spending – on health sector, education, infrastructure, defence. Taxation policy – income tax, sales tax (VAT), corporate tax, capital gains tax.
Fiscal policy and aggregate demand
Government spending – increase in G spending → AD shifting right e.g. Gov places £10 billion order for new school buildings → building contractor has increased demand for output → hires more staff and increases production.
Income tax cut → consumption increases → AD shifting right Corporate tax cut → investment increases → AD shifting right If tax cuts are seen as temp then AD shift may be smaller
The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.
Positive impact - The Gov buys £10 billion of buildings from Bob and Co, → demand from gov raises employment and profits at Bob and Co → as workers see higher earnings and firm owners see higher profits → increase own spending on consumer goods and so on… This is the multiplier effect.
Negative impact could be that spending on foreign goods may increase → neg impact on AD as imports increase. Size of multiplier depends on marginal propensity to consume and import.
SHOW IMPACT OF MULTIPLIER USING KEYENESIAN CROSS DIAGRAM
Size of the Multiplier
MPC – marginal propensity to consume – the fraction of extra income that a household consumes rather than saves. E.g. if MPC = ¾ it means that for every extra pound a household earns it speand ¾’s and saves ¼ of it.
Multiplier = 1 + MPC + MPC^2 + MPC^3 + … or Multiplier = 1/(1 – MPC) E.g. if MPC is ¾, the multiplier is 1/(1 – ¾), which is 4. If gov initial purchase was 10 billion then times by 4 = spending generated £40 billion of demand for goods and services. Hence, the larger the MPC...
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