FISCAL POLICY

A. Main components of fiscal policy

Fiscal policy refers to decisions about government spending and tax collections.
Therefore, two main components of fiscal policy are:

1. Government purchases
 An increase in government purchases eliminates a
contractionary gap.
 A decrease in government purchases eliminates an
expansionary gap.
2. Taxes and transfer payments
 These payments are not for the costs of current goods and services,
so t h e y are not part of G and do not affect PAE directly.
 Taxes and transfer payments affect disposable income, Y–T.
 Tax increases and decreases in transfer payments
decrease disposable income and reduce PAE.
 Tax cuts and increases in transfer payments increase
disposable income and PAE.
B. Balanced budget multiplier

A balanced budget multiplier refers to the short-run effect on equilibrium GDP of an

equal change in government expenditure and net taxes.
o Increasing spending on one hand and decreasing spending somewhere else.
o The exogenous increase in household payments will be spent according
to their MPC; c.

C. Complexities in using fiscal policy.

There are complexities in using fiscal policy to try to change output precisely:
- Fiscal policy and the supply side
o Fiscal policy affects potential output and PAE: government spending on public
capital significantly influences potential GDP growth.
o Taxes and transfers play a role in affecting incentives and, thus, economic
behaviour.
- The problem of deficits
o Expansionary fiscal policy leads to deficits, which reduces national savings. →
It reduces investment in new capital (an essential source of long-term economic
growth).
o Makes increasing spending or cutting taxes a less attractive option.
- Fiscal policy is relatively inflexible.