Fiscal policy and
demand management
Learning Outcome: To understand
the issues of using fiscal policy to
manipulate AD
The objectives of fiscal policy
 Fiscal policy is decisions about
government spending, taxation and
borrowing
 It is an instrument of policy used to
achieve 3 main policy goals or
objectives
 To improve macro performance –
used to achieve the four main
macro objectives by influencing
the demand side of the economy
(covered in this section) and the
supply side (next section)
 To achieve a more desirable
distribution of income and wealth
 To correct market failure at the
micro level
Demand Management
 Using fiscal policy to manipulate AD
is called Demand Management
 By reducing tax or spending more
withdrawals will decrease and
injections will increase thereby
increasing the circular flow of
money
 This will be further increased by the
multiplier effect (according to
Keynesians)
 This is expansionary fiscal policy –
used when there is a negative
output gap
 The opposite is deflationary fiscal
policy reducing AD – used when
there is a positive output gap
Automatic stabilisers
 These automatically increase when
the economy is going into a
recession
 They automatically fall when
national income begins to rise
 Government spending and taxation
are both automatic stabilisers
 When the economy goes into
recession and unemployment rises
government increases spending on
benefits
 The fall in AD is therefore less than
it would otherwise have been
 Tax revenues fall too at a higher
rate than the fall in income
 This is due to the fact that tax rates
tend to be higher on marginal
income than on average income
Automatic or built-in
stabilisers – mechanisms
which reduce the impact of
changes in the economy on
national income
Automatic stabilisers
 An example to show you how the
tax falls at a faster rate than the fall
in income
 A worker paid on commission sells
less in a recession
 Her tax rate might fall from 40% to
20%
 If household spending has to be cut
then it is more likely to be on
consumer durables taxed at 20%
VAT than zero rated goods such as
food
 With the government collecting les
tax disposable incomes are higher
and consumption is at a higher level
that it would be without the stabiliser
Automatic or built-in
stabilisers – mechanisms
which reduce the impact of
changes in the economy on
national income
Automatic stabilisers
 When the economy goes into
a boom
 Unemployment decreases
 Government spending falls as
the benefits fall automatically
 Tax revenue increases at a
faster rate than income
 An unemployed person will pay
very little tax
 Once they get jobs they start to
pay substantial amounts of direct
and indirect tax
 AD is lower than it would
otherwise be with these
automatic stabilisers
Automatic or built-in
stabilisers – mechanisms
which reduce the impact of
changes in the economy on
national income
Active or discretionary
fiscal policy to manipulate
AD
 This does not rely on the economy
automatically changing the amount
of government spending or
collecting tax
 This is deliberate manipulation of
government expenditure and
spending to influence the economy
 In the 1920s and 1930s the
orthodox classical thinking of the
day was that governments should
maintain balanced budgets
whatever the state of the economy
 The argument was that for every £1
of government spending would
crowd out private sector spending
 This would cancel out the affect of
the government spending on AD
Active or discretionary
fiscal policy – the
deliberate manipulation of
government expenditure
and taxes to influence the
economy
Active or discretionary
fiscal policy to manipulate
AD
 Keynes argued that crowding out
did not take place in an economy
that was in a depression
 Post war (50s and 60s)
governments used fiscal policy to
manage demand
 At this time unemployment was low
and demand management was just
a matter of fine tuning
 In the 1970s and 80s they were
suffering from high unemployment
and high inflation and returned to
the crowding out argument
 Today the mainstream view is that
AD should be manipulated through
the use of monetary policy
 Fiscal policy is best left to deal with
correcting market failure or
changing inequality because……
Fine tuning – the attempt
by government to move
the economy to a very
precise level of
unemployment, inflation
etc
The limitations of using fiscal policy to
manipulate AD
 Conflicting policy objectives
 Governments in the past believed that they
could achieve a variety of objectives using
fiscal policy
 This led to stop-go cycles
 When the economy was in recession the
government would use expansionary fiscal
policy to reduce unemployment and stimulate
growth
 The economy would overshoot
 In the subsequent boom inflation would rise and
the BoP would deteriorate
 Government would put on the brakes and use
deflationary fiscal policy sending the economy
back into recession
 This was made worse by creating booms
around election times
 In contrast monetary policy targets only one
variable – the rate of inflation
 Giving monetary policy to the MPC removes
election time manipulation
Stop/go cycle – the
movement from boom to
recession in the trade
cycle
The limitations of using fiscal policy to
manipulate AD
 Time lags
 Assume government announces £500m increase
in civil servant salaries and £500m increase in
road building
 If the multiplier were 2 this would lead to a
£2000m increase in circular flow income (in the
Keynesian model)
 However this could take years to work through
the economy
 Salaries might work quickly
 Road building make take years to even start
 Government has to take these time lags into
consideration when using fiscal policy to
manipulate AD
 If it wants to make quick changes it has to
change taxes and items of expenditure that have
an immediate impact on AD
 E.g. income tax rates, social security payments
and public sector wages
 Not road building or hospital building
The limitations of using fiscal
policy to manipulate AD
 Time lags
 Governments have been accused of
destabilising the economy using fiscal
policy
 If the economy was starting to move
into a boom on its own accord and the
government at the same time used
expansionary policy there would be a
positive output gap and inflation
 Some economists argue that the
inability to predict time lags accurately
makes it impossible to use fiscal policy
to fine tune the economy
The limitations of using fiscal
policy to manipulate AD
 Inadequacy of economic data
 Active fiscal policy assumes that the
Chancellor knows the current state of
the economy
 But…statistics are notoriously
unreliable
 Unemployment and inflation stats are
not revised after publication
 National income and BoP stats are
frequently revised
 Often two or more sets of figures
which should match fail to do so
 If there is a deficit on the BoP the
chancellor will not know how much of
this is genuine deficit and how much is
inaccurate recording of stats
 Fine tuning can then be very difficult
• Insert Q3
The limitations of using fiscal
policy to manipulate AD
 Inadequate economic knowledge
 Active fiscal policy assumes that we
know how the economy behaves
 There is scepticism that economics
will ever be able to predict changes in
variables to the last few %
 Many of the variables that
governments wish to control have very
small values
 A government may wish to reduce
growth from 3% to 1.5%
 Fiscal policy is unlikely ever to be
sufficiently sensitive to achieve exactly
that 1.5% fall
The limitations of using fiscal
policy to manipulate AD
 The inadequacy of the model
 Computer based macro forecasting models used
today are highly complex
 At best they provide an approximation of
possible outcomes
 The data (particularly the most recent data) fed
into the models may not be accurate
 They cannot forecast economic shocks
 Until the 1980s UK forecasting models failed to
take into account the importance of large
changes in house prices for AD
 Today there is controversy about the significance
of the IT revolution
 Some economists say it has improved
productivity that is not showing in traditional
models
 The models are not showing the potential growth
without inflation
 Others are sceptical and remember the miracle
economy of the 1980s created through supply
side reforms that led to an overheated economy
The limitations of using fiscal
policy to manipulate AD
 Fiscal policy and monetary policy
 Fiscal policy cannot be independent
of monetary policy
 If government increases borrowing it
has to be financed
 Governments can print money to do
this
 Printing money increases the money
supply and is potentially inflationary
 Printing money and increasing the
money supply is a monetary policy
decision
 Hence fiscal policy and monetary
policy are interlinked
The limitations of using fiscal
policy to manipulate AD
 Fiscal policy and monetary policy
 Governments can avoid printing money
by borrowing from the private sector
 This increases the demand for borrowed
funds and interest rates are likely to rise
 Higher interest rates will reduce the
willingness of the private sector to borrow
and spend
 The increase in AD from a higher G will to
some extent by offset by reduced AD
from decrease in I
 Allowing interest rates to rise is part of
monetary policy and again this shows
how monetary and fiscal policy are linked
The limitations of using
fiscal policy to manipulate
AD
 Fiscal policy and monetary policy
 Higher government borrowing may not
lead to higher interest rates if the
economy is in a deep depression
 This is called a Liquidity Trap situation
Liquidity trap – where the economy is in such a deep
depression that interest rates have fallen as far as
they will ever go. This means that governments
cannot use monetary policy through reducing interest
rates to stimulate AD. Only fiscal policy can help
revive demand
The limitations of using fiscal policy
to manipulate AD
 The national debt
 Since the 2nd WW many governments have
abandoned attempts to balance their
budgets
 They find it politically easier to spend more
than they tax and borrow the difference
 The problem is that the borrowing may
become very difficult to service (pay the
interest)
 They may get to the point where the
majority of revenue taken in tax is used to
pay the interest – they still have to pay the
capital
 Eventually lenders will be scared that the
government will default on its debt
 The country may have its credit rating
reduced
 This will increase the amount of interest the
country has to pay on its debt
The limitations of using fiscal
policy to manipulate AD
 The national debt
 In the short term the government
could print money
 More supply may lead to inflation
 Inflation reduces the value of the
debt
 This is not a long term solution
 Lenders will demand much higher
interest rates if there is high inflation
 Budget deficits will continue to
increase the size of the national
debt
The limitations of using fiscal
policy to manipulate AD
 Stability and growth pact
 When plans were made to create
the European Monetary Union it
was recognised that large budget
deficits and a sizable national debt
could destabilise the economies of
individual member countries and
therefore the whole union
 As a condition of membership the
fiscal deficits could not be more
than 3% of GDP
 The national debt of a country could
not be more than 60% of GDP
 This stability and growth pact
further limits the ability of
governments of member countries
to use fiscal policy to steer
economies
The limitations of using fiscal
policy to manipulate AD
 Code for Fiscal Stability
 In the UK the government has had
its own set of fiscal rules since 1998
 The golden rule states that the
government will only borrow to
invest (to build hospitals etc) and
not to fund current spending (e.g.
wages, salaries, rent, heating etc)
 The sustainable investment rule
states that the national debt will be
kept at 40% of GDP
 These rules would limit the use of
fiscal policy to manipulate AD
 Have they kept to these rules
recently?
 In March 2014, public sector net
debt was £1,268.7 billion,
equivalent to 75.8% of gross
domestic product (GDP).
 It has broken its own fiscal stability
rule of 40% and the European rule
of 60%
The UK national debt is the total
amount of money the British
government owes to the private
sector and other purchasers of
UK bonds.
In 2013/14 public sector net
borrowing was £107.7 billion (7.4%
of GDP)
Again it has broken the 3%
European rule
Homework
Read Unit 74 (Anderton)
Question 5 June 2010
The Budget Report of April 2009 estimated that UK
government borrowing for 2009-10 would be
£175 billion, or about 12% of GDP.
• Explain possible economic reasons for changes
in the level and distribution of government
expenditure. (15 marks)
• To what extent should government borrowing be
a cause for concern? (25 marks)
First part of the first question - explain reasons for changes in the level
of expenditure, e.g.
 cyclical: in a recession, for example, welfare spending will
automatically increase as more of the population become eligible,
but government may also decide to spend more over and above
this in order to minimise the recession and initiate a multiplier
effect through capital project schemes
 new decisions made over the provision of merit goods
 new decisions made over the provision of public goods
 to influence the distribution of income
 changed priorities regarding the drive to reduce poverty and the
general standard of living of the population
 to underpin key sectors of the economy, e.g. financial services, the
car industry
 changing taxation revenue allows an increase in, or makes it
necessary to reduce, government spending
 changing views on government borrowing to finance spending
plans
You would probably only want to explain a
couple of these and then the same for the
distribution
Second part of first question: explain reasons for changes in the
distribution of government expenditure, e.g.
 changing economic circumstances, brought about by changing domestic or
international conditions, which in addition to changing the level of
spending, may cause governments to have to re-distribute spending, e.g.
reducing defence spending in order to give more support to domestic
sectors of the economy, e.g. banks or postponing capital projects in order
to increase welfare payments
 the changed priorities of a new government compared to the previous
government or a long-standing existing government trying to breathe new
life into itself, e.g. action on poverty might cause less spending on
transport
 demand-determined items of expenditure (perhaps reference to a
cyclical/structural distinction)
 the impact of an ageing population
 changing levels of concern internationally over environmental issues forces
the UK
 government to commit more spending to the problem which could reduce,
for example, the government financial support for the arts/culture etc
 public or private sector investigations and reports highlight failings in key
parts of the public sector, notably education and the NHS, and these are
therefore given priority in spending over defence, for example the topical
issue of interest payments on the National Debt