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CHAPTER 4:
FISCAL POLICY AND FOREIGN TRADE

CONTENTS:

•1. Fiscal Policy

•2. Foreign Trade

•3. Exercise

What is Fiscal Policy?

• Fiscal policy refers to the use of government spending and tax policies to
influence economic conditions, including demand for goods and
services, employment, inflation, and economic growth.

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1. FISCAL POLICY.
1.1 Targets and instruments of fiscal policy
• Fiscal policy is government policy on spending and taxes. It
affects the size of government deficits and thus government
debt.
• Stabilization policy is government action to keep aggregate
demand and actual output close to potential output.
• Potential output is key economic concept as its evolution
determines how fast an economy can grow in a sustainable
way.
• It is typically thought of as the highest level of economic
activity that can be sustained by means of the available
technology and factors of production, in particular labour and
capital, without creating inflationary pressure.

1. FISCAL POLICY.
1.1 Targets and instruments of fiscal policy
• Natural unemployment is often defined as the lowest rate
of unemployment an economy will reach.

• It is “natural” because its causes are things other than the

problems caused by a bad economy.

• The objective of fiscal policy is to create healthy

economic growth.
• Two kinds of instruments of fiscal policy including: T and
G.
• There are two types of fiscal policy.

1.1 Targets and instruments of monetary policy

Expansionary Fiscal Policy

Increase G or/and decrease T

Fiscal Policy
Contractionary Fiscal Policy
decrease G or/and increase T

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1.2 The effect of fiscal policy. chính sách mở rộng được chính phủ sử dụng như để kết thúc một chu kì kinh doanh

• Expansionary: It stimulates economic growth. Governments chính sách thu hẹp được sử dụng để làm chậm phát triển kinh tế nhằm giảm sự lạm phát
use it to end the contraction phase of the business cycle: a kinh tế khi kinh tế phát triển trong thời gian dài sẽ có thể dẫn tới lạm phát -> gây tổn hại
recession. đến tiêu chuẩn sống cũng như là suy thoái kinh tế
• The government either spends more, cuts taxes, or both. The
idea is to put more money into consumers' hands, so they
spend more. The increased demand forces businesses to add
jobs to increase supply.

• Contractionary: Its goal is to slow economic growth. That's to

stamp out inflation. The long-term impact of inflation can
damage the standard of living as much as a recession.
• The tools of contractionary fiscal policy are used in reverse.
Taxes are increased, and spending is cut.

mở rộng :
1.2 The effect of fiscal policy. tăng G và giảm T dẫn đến thu nhập tăng => cầu tăng => tổng cầu tăng => GDP tăng
=> cung tăng => tỉ lệ thất nghiệp thực giảm => sản lượng thực < sản lượng tiềm năng
• Expansionary fiscal policy: co hẹp ; ngược lại => lạm phát giảm
G / and T -> AD -> Y , Ut
(Yt < Yp.)

• Contractionary fiscal policy:

G /và T -> AD -> Y , Ut , Inflation
(Yt > Yp)

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1.3 Quantification for fiscal policy

• Adjust Yt is approximately equal to Yp: keep aggregate
demand and actual output close to potential output

• When (Yt< Yp or Yt > Yp) : rY.

rY = Yp – Yt

• Yt = Yp:
Changes in AD: rAD:

rY = k. rAD or rAD = rY / k

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1.3 Quantification for fiscal policy

If:
• Just changes G, keeps T constantly:
rG = rAD
• Just changes T, keeps G constantly : changes T
via C
rT = - rAD/ Cm

Cut T: rT < 0
rYd = - rT
rC = Cm. rYd = - Cm. rT
ÞrAD = rC = -Cm. rT
Þ rT = - rAD/Cm

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• Changes both T and G:

rG - CmrT = rAD = r Y / k

• rG = rAD 1
• rT = - rAD 2/Cm or rAD 2 = -Cm. rT
• Because: rAD 1 + rAD 2 = rAD
• So:
• rG – Cm. rT = rAD

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Limitations of Fiscal Policy

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1. Time-lags
• There is generally some interval between the time when
a particular action is needed and the time when a fiscal
measure has its impact felt. The duration of this interval
determines the extent to which a specific fiscal measure
can be effective.
• There may be considerable time-lags between changing
taxes and changes in household spending.

• Higher taxes may have a disincentive effect on work and

enterprise, as some individuals alter their perception of
the relative costs and benefits of work, in comparison
with leisure.

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2. Forecasting:

• Another most serious limitation of fiscal policy is the

practical difficulty of observing the coming events of
economic instability.

• Unless they are correctly observed the amount of

revenue to be raised, the amount of expenditure to be
incurred or the nature and extent of budget balance to be
framed cannot be suitably planned.

• In fact, success of fiscal measures depends on the

accurate predictions of various economic activities. In its
absence, it proves to be a little bit erratic.

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In trying to promote growth or

create new jobs a fiscal
stimulus through increased
government spending can be
inflationary, especially if the
spending is too fast, such as
with an increase in current
spending on wages.

This can be seen in the

diagram above, with the shift
in AD pulling up the price
level, from P 1 to P 2.

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2. FOREIGN TRADE POLICY

2.1 Higher export demand policy
Higher export demand, export changes: rX
a AD changes: rAD = rX
a Y changes rY = k. rAD = k. rX

AD AD2

AD1

rAD = rX

450
Y
Y1 Y2

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Changes in trade balance:

M
X,M
X2 Because: M = Mo + Mm.Y
rX arM = Mm.rY
X1
rM = Mm.k.rX
Y1 Y2 Y

AD
AD2

AD1

= rX
rAD

450

Y1 Y2 Y

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Changes in trade balance:

M
X,M
X2 Because: M = Mo + Mm.Y
rX arM = Mm.rY
X1
rM = Mm.k.rX
Y1 Y2 Y If:
AD – Mm.k < 1
AD2
a rX > rM : tend to
surplus
AD1 – Mm.k > 1
= rX a rX < rM : tend to
rAD
deficit
– Mm.k = 1
a r X = r M : balance
450

Y1 Y2 Y

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2.2 Import restriction policy

• Decrease in import: rM (decrease Mo, increase ADo)

a Increase AD: rAD = -rM

a Y increase : rY = k. rAD = - k. rM
a Effects:
• Increase in output
• More employment AD AD3
• Decrease unemployment
AD2

AD1

AD02
ADo1
•Import restriction decrease
Mm: AD1 a AD3
450

Y1 Y2 Y

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Summary
• 1. Fiscal policy refers to the policies of the government
regarding its expenditure, investment spending and taxation.

2. The objective is to find a balance between tax rates and

public spending to ensure a healthy economic growth without
causing inflation to rise.

3. A fiscal expansion aims to stimulate aggregate demand and

growth through reducing taxes and/or increasing government
spending.

4. A contraction in fiscal policy decreases government

spending and/or increases taxation to reduce aggregate
demand and output.

5. Fiscal policies tend to impact demand directly and quickly.

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