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→ Fiscal policy is the use of government revenue collection (mainly taxes) and

expenditure (spending) to influence the economy. According to Keynesian economics, when the
government changes the levels of taxation and government spending, it influences aggregate
demand and the level of economic activity. Fiscal policy can be used to stabilize the economy
over the course of the business cycle.
→ The two main instruments of fiscal policy are:
1. Changes in the level and composition of taxation
2. Government spending in various sectors.
These changes can affect the following macroeconomic variables, amongst others, in an
1. Aggregate demand and the level of economic activity;
2. Savings and Investment in the economy
3. The distribution of income
Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with
taxation and government spending and is often administered by an executive under laws of a
legislature, whereas monetary policy deals with the money supply, lending rates and interest
rates and is often administered by a central bank.
→ The purpose of Fiscal Policy:
1. Stimulate economic growth in a period of a recession.
2. Keep inflation low (UK government has a target of 2%)
3. Fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic
→ The three main stances of fiscal policy are:
1. Neutral fiscal policy is usually undertaken when an economy is in
equilibrium. Government spending is fully funded by tax revenue and overall the budget
outcome has a neutral effect on the level of economic activity.
2. Expansionary fiscal policy involves government spending exceeding tax revenue, and is
usually undertaken during recessions.
3. Contractionary fiscal policy occurs when government spending is lower than tax revenue,
and is usually undertaken to pay down government debt.
→ Methods of funding
Governments spend money on a wide variety of things, from the military and police to
services like education and healthcare, as well as transfer payments such as welfare benefits.
This expenditure can be funded in a number of different ways:
1. Taxation
2. Seigniorage, the benefit from printing money
3. Borrowing money from the population or from abroad
4. Consumption of fiscal reserves
5. Sale of fixed assets (e.g., land)

Borrowing : A fiscal deficit is often funded by issuing bonds, like treasury
bills or consols and gilt-edged securities. These pay interest, either for a fixed period or
indefinitely. If the interest and capital requirements are too large, a nation may default on its
debts, usually to foreign creditors. Public debt or borrowing refers to the government borrowing
from the public.
Consuming prior surpluses : A fiscal surplus is often saved for future use, and may be invested in
either local currency or any financial instrument that may be traded later once resources are
needed; notice, additional debt is not needed. For this to happen, the marginal propensity to save
needs to be strictly positive.
→ Terms relating to fiscal policy:
1. Fiscal Stance : This refers to whether the government is increasing AD or decreasing AD,
e.g. expansionary or tight fiscal policy
2. Fine Tuning : This involves maintaining a steady rate of economic growth through using
fiscal policy. However this has proved quite difficult to achieve precisely.
3. Automatic fiscal stabilisers – If the economy is growing, people will automatically pay
more taxes (VAT and Income tax) and the Government will spend less on unemployment
benefits. The increased T and lower G will act as a check on AD. But, in a recession the
opposite will occur with tax revenue falling but increased government spending on
benefits, this will help increase AD
4. Discretionary fiscal stabilisers – This is a deliberate attempt by the government to affect
AD and stabilise the economy, e.g. in a boom the government will increase taxes to
reduce inflation.
5. The multiplier effect. When an increase in injections causes a bigger final increase in
Real GDP.
6. Injections (J) – This is an increase of expenditure into the circular flow, it includes govt
spending(G), Exports (X) and Investment (I)
7. Withdrawals (W) – This is leakages from the circular flow This is household income that
is not spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net
Imports (M)