Econ

Introduction

Fiscal policy involves the use of government spending, taxation and borrowing to affect the level and growth of aggregate demand, output and jobs

Fiscal policy is also used to change the pattern of spending on goods and services

It is also a means by which a redistribution of income & wealth can be achieved

It is an instrument of intervention to correct for free-market failures

Changes in fiscal policy affect aggregate demand (AD) and aggregate supply (AS)

In the UK, the Treasury (pictured right) is in charge of fiscal policy decisions

Fiscal Policy and Aggregate Demand

Traditionally fiscal policy has been seen as an instrument of demand management. This means that changes in government spending, direct and indirect taxation and the budget balance can be used “counter-cyclically” to help smooth out some of the volatility of national output particularly when the economy has experienced an external shock and is in a recession.

* The Keynesian school argues that fiscal policy can have powerful effects on demand, output and employment when the economy is operating below full capacity national output, and where there is a need to provide a demand-stimulus.

* Monetarist economists believe that government spending and tax changes only have a temporary effect on aggregate demand, output and jobs and that the tools of monetary policy are a more effective instrument in controlling inflation and maintaining macroeconomic stability

The fiscal policy transmission mechanism

This flow-chart identifies some of the channels involved with the fiscal policy transmission mechanism – in the example shown we focus on an expansionary fiscal policy designed to boost demand and output

The multiplier effects of an expansionary fiscal policy depend on how much spare productive capacity the economy has; how much of any increase in disposable income is spent rather than saved or spent on imports. And also the effects of fiscal policy on variables such as...