Monetary and fiscal policy in the

euro area
Introduction by Dr. Willem F. Duisenberg, President of
the European Central Bank, at the International
Monetary Conference, Berlin, 3 June 2003.
I would like to begin today by situating my analysis of the current situation in the context
of the institutional framework for macroeconomic policies in the euro area. In the euro
area, fiscal policies remain under the exclusive responsibility of national governments.
Contrary to monetary policy, fiscal policies are decentralised. In this set-up, in which
there is a multiplicity of actors, certain rules are indispensable. Rules provide a clear
allocation of responsibilities and thereby set appropriate incentives. If they are abided by,
these rules create an efficient co-ordination device for budgetary policies within the euro
area. In addition, the setting of numerical limits and goals provides clear yardsticks for
other policy-makers and the general public to gauge the current and future course of
fiscal policies, thus facilitating surveillance and peer pressure.

The Maastricht Treaty states that countries should avoid excessive deficits. Important
reference values for this assessment are a government deficit level of 3% of GDP and a
debt-to-GDP ratio of 60%. In addition, through the Stability and Growth Pact, countries
have committed themselves to respect the objective of a budgetary position close to
balance or in surplus over the medium term. At the current juncture, compliance with the
fiscal rules is not satisfactory in several euro area countries, with some of them
experiencing or expecting fiscal deficits above the 3%-of-GDP reference value. These
countries now have to pay the price for not having sufficiently consolidated their public
finances when economic growth was strong.

For these countries, there is a need to abide by the Pact and therefore prevent or correct
excessive deficits, so that confidence in the macroeconomic framework of the euro area is
boosted. However, some of the euro area countries still facing high, or even excessive,
deficits are not sufficiently forcefully implementing the consolidation measures needed to
reach sound budgetary positions. At this stage, these countries should focus on the
implementation of growth-oriented consolidation policies that strengthen the productive
forces of the economy. Such policies would support confidence of economic agents and
therefore economic growth also in the short term.

By contrast, many other euro area countries have already reached medium-term
budgetary positions close to balance or in surplus. They can let automatic stabilisers
operate freely, resulting in the current economic environment in a deterioration of the
headline budget balance but not in excessive deficits.
The importance of the functioning of automatic stabilisers in the euro area should not be
underestimated. In the euro area, the contribution to economic stabilisation made by these
stabilisers is generally higher, on average, than in other industrialised countries due to the
high sensitivity of revenues and expenditures to economic fluctuations in Europe.

However, we have serious doubts about the efficiency of discretionary fiscal policies.
Activist policies may have pro-cyclical effects, given the time-lags involved. In addition,
they risk undermining the confidence of economic agents in the fiscal framework and in
its stability.

As regards the monetary policy of the ECB, let me start by presenting the principle which
forms the foundation of the macroeconomic institutional framework in the euro area. This
principle is that of a sound monetary policy aimed at maintaining price stability.

The ECB's Governing Council takes its monetary policy decisions within the framework
of a well-designed monetary policy strategy. Less than one month ago, we confirmed our
definition of price stability as a "year-on-year increase in the Harmonised Index of
Consumer Prices (HICP) for the euro area of below 2%". We also confirmed our
medium-term orientation. At the same time, we clarified that in the pursuit of price
stability we aim to maintain inflation rates below but "close to 2%" over the medium
term. This clarification underlines the ECB's general commitment to provide a sufficient
safety margin to guard against potential risks of deflation. It also addresses the issue of
the possible presence of a measurement bias in the HICP and the implications of inflation
differentials within the euro area.

Let me turn now to the factors which need to be taken into consideration by monetary
policy at the current juncture. The first few months of this year were dominated by the
uncertainty related to the escalation of geopolitical tensions in the Middle East. This
environment, which was also characterised by rising oil prices, was clearly not beneficial
for investment and, more generally, economic activity in the euro area and at the global
level. As a result, economic growth was relatively weak in early 2003 and expectations
for economic growth, at least for this year, have had to be scaled back.

The rapid conclusion of the military activities was accompanied by a normalisation in oil
prices and a rebound in stock markets. Both developments indicate that market fears of a
worst-case scenario of a prolonged phase of acute geopolitical tensions, with negative
implications for economic growth, are fading away. Still, the signals coming from
economic indicators – mainly the results of surveys on the confidence of consumers and
producers – have remained mixed over recent months and have complicated the
assessment of the economic situation.

In this regard, it remains difficult to disentangle factors which may have a transitory
effect on economic activity from more entrenched trends. Overall, the information that
we have gathered so far points to the continuation of weak economic growth throughout
the first half of 2003. However, we expect some acceleration in economic activity in the
second half of this year and thereafter. This outlook seems to be in line with financial
market expectations. Let me review some of the factors which have shaped this outlook.

First, corporate investment continues to be hesitant. This may be related to the process of
adjustment of the balance sheets of corporations, following the rapid accumulation of
debt until 2000. The effects of this build-up of debt have been compounded by the
significant fall in the value of financial assets from the peak reached in early 2000. There
is uncertainty over the size of the adjustment still needed in the euro area corporate sector
in order to enhance productivity and profitability.

At the same time, we should not forget that the low level of interest rates that has
prevailed for quite a long time in the euro area has helped firms in this adjustment
process and should foster a recovery in investment. In addition, the financial position of
households in the euro area has remained healthy overall. The stability of the saving ratio
in the past years indicates that in the euro area as a whole there is no need for significant
adjustments which could constrain the recovery in consumption. The recent fall in oil
prices should also support private consumption.

As regards the external balance, given the extent and the length of the period of the
appreciation of the exchange rate of the euro, some restraining effects on exports of the
euro area will be felt in the period ahead. However, we should keep in mind that after the
correction which has occurred over the past 12-14 months, the competitive position of
euro area producers, measured by indicators of real exchange rates, is now back in line
with long-term averages. Furthermore, the effects of the appreciation of the exchange rate
of the euro on aggregate demand may be mitigated by the significant improvements in the
terms of trade, as the lower import prices will be conducive to a pick-up in consumption.
In addition, the effects of the changes in the exchange rate on trade are likely to be more
than compensated for in the coming years by the expected acceleration in economic
activity world-wide.

On the latter aspects I should however not conceal that we also see some downside risks
to the global recovery in economic activity. Notably, the possible correction of
macroeconomic imbalances in other major economies remains a factor of risk. In
addition, we cannot exclude that the SARS epidemic may have negative supply and
demand effects, although it is difficult at this juncture to assess the possible implications.

What does all this mean for the outlook for price stability? Obviously, prospective
developments in economic activity should contribute to restraining inflationary pressure
in the euro area in the coming years. In this respect, after a period of rising wage growth,
despite a context of subdued economic growth in 2001 and early 2002, we have seen
signs of stabilisation of wage growth more recently. The effects of recent exchange rate
developments will also make a significant contribution to reducing inflationary pressure,
although some of the effects may be visible only with a certain time-lag.
Over the last couple of months, inflation has remained somewhat above 2%. We expect
that, after hovering around 2% over the coming months, consumer price inflation should
fall more significantly in 2004.

Partly due to the high volatility observed in financial markets in the past, but also due to
the low level of interest rates, the euro area economy has continued to accumulate liquid
assets significantly above the amount needed to sustain non-inflationary growth. The
concerns about this situation are, however, limited, at least as long as economic activity
remains subdued. The easing of geopolitical tensions and the recent stabilisation in
financial markets should support an unwinding of these portfolio shifts over time. In
addition, the moderate growth in loans to the private sector indicates that the growth in
monetary aggregates does not reflect internal demand dynamics.

Thus, overall, not least due to the appreciation of the euro, inflationary pressures have
declined significantly over recent months. This assessment will be reflected in our
deliberations on monetary policy.

As the organiser has asked me to also say a few words on the "policy mix" in the euro
area, let me briefly conclude with some remarks on this topic. I think that the
macroeconomic policy framework in the euro area is appropriate to ensure sustained and
non-inflationary economic growth. Fiscal policy should contribute to maintaining an
environment of macroeconomic stability. At the same time, the monetary policy of the
ECB takes into account the fiscal policy stance, as one of the factors which contribute to
the outlook for price stability over the medium term. In this respect, an efficient
assignment of objectives and instruments, together with a clear division of
responsibilities, is in place in the euro area. The policy objectives and the policy
execution framework are known to all policy actors. An open exchange of views and
information between individual policy actors can assist the overall outcome if this
enhances an understanding of the objectives and strategies to pursue them.

However, there cannot be any scope for an active co-ordination of fiscal and monetary
policies. Such active co-ordination is bound to be ineffective, given the inability of both
fiscal and monetary policy-makers to fine tune economic developments. Commitments to
ex ante co-ordination between fiscal and monetary policies may blur the responsibilities
of monetary and fiscal authorities and ultimately reduce their incentives to pursue their
objectives. The economic outcome of such co-ordination is likely to be worse than the
conduct of policies within the existing institutional set-up as only the latter ensures
genuine accountability

Fiscal policy
In economics, fiscal policy is the use of government spending and revenue
collection to influence the economy.[1]

Fiscal policy can be contrasted with the other main type of economic
policy, monetary policy, which attempts to stabilize the economy by
controlling interest rates and the supply of money. The two main instruments
of fiscal policy are government spending and taxation. Changes in the level
and composition of taxation and government spending can impact on the
following variables in the economy:

 Aggregate demand and the level of economic activity;

 The pattern of resource allocation;
 The distribution of income.

Fiscal policy refers to the overall effect of the budget outcome on economic
activity. The three possible stances of fiscal policy are neutral, expansionary
and contractionary:

 A neutral stance of fiscal policy implies a balanced budget where G = T

(Government spending = Tax revenue). Government spending is fully
funded by tax revenue and overall the budget outcome has a neutral
effect on the level of economic activity.

 An expansionary stance of fiscal policy involves a net increase in

government spending (G > T) through rises in government spending or a
fall in taxation revenue or a combination of the two. This will lead to a
larger budget deficit or a smaller budget surplus than the government
previously had, or a deficit if the government previously had a balanced
budget. Expansionary fiscal policy is usually associated with a budget
deficit.

 A contractionary fiscal policy (G < T) occurs when net government

spending is reduced either through higher taxation revenue or reduced
government spending or a combination of the two. This would lead to a
lower budget deficit or a larger surplusthan the government previously
had, or a surplus if the government previously had a balanced budget.
Contractionary fiscal policy is usually associated with a surplus.

Fiscal policy was invented by John Maynard Keynes in the 1930s.

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:

 Taxation
 Seignorage, the benefit from printing money
 Borrowing money from the population, resulting in a fiscal deficit.
 Consumption of fiscal reserves.
 Sale of assets (e.g., land).

Funding the deficit

A fiscal deficit is often funded by issuing bonds, like treasury bills or consols.
These pay interest, either for a fixed period or indefinitely. If the interest and
capital repayments are too large, a nation may defaulton its debts, usually to
foreign creditors.

Consuming the surplus

A fiscal surplus is often saved for future use, and may be invested in local
(same currency) financial instruments, until needed. When income from
taxation or other sources falls, as during an economic slump, reserves allow
spending to continue at the same rate, without incurring a deficit.

Economic effects of fiscal policy

Fiscal policy is used by governments to influence the level of aggregate
demand in the economy, in an effort to achieve economic objectives of price
stability, full employment and economic growth. Keynesian
economics suggests that adjusting government spending and tax rates are
the best ways to stimulateaggregate demand. This can be used in times of
recession or low economic activity as an essential tool in providing the
framework for strong economic growth and working toward full employment.
The government can implement these deficit-spending policies due to its size
and prestige and stimulate trade. In theory, these deficits would be paid for
by an expanded economy during the boom that would follow; this was the
reasoning behind the New Deal.

During periods of high economic growth, a budget surplus can be used to

decrease activity in the economy. A budget surplus will be implemented in
the economy if inflation is high, in order to achieve the objective of price
stability. The removal of funds from the economy will, by Keynesian theory,
reduce levels of aggregate demand in the economy and contract it, bringing
about price stability.

Some classical and neoclassical economists argue that fiscal policy can have
no stimulus effect; this is known as the Treasury View, and categorically
rejected by Keynesian economics. The Treasury View refers to the theoretical
positions of classical economists in the British Treasury who opposed Keynes
call for fiscal stimulus in the 1930s. The same general argument has been
repeated by neoclassical economists up to the present day. From their point
of view, when government runs a budget deficit, funds will need to come
from public borrowing (the issue of government bonds), overseas borrowing
or the printing of new money. When governments fund a deficit with the
release of government bonds, an increase in interest rates across the market
can occur. This is because government borrowing creates higher demand for
credit in the financial markets, causing a lower aggregate demand (AD),
contrary to the objective of a budget deficit. This concept is called crowding
out.

Other possible problems with fiscal stimulus include the time lag between the
implementation of the policy and detectable effects in the economy and
inflationary effects driven by increased demand. In theory, fiscal stimulus
does not cause inflation when it uses resources that would have otherwise
been idle. For instance, if a fiscal stimulus employs a worker who otherwise
would have been unemployed, there is no inflationary effect; however, if the
stimulus employs a worker who otherwise would have had a job, the stimulus
is increasing demand while labor supply remains fixed, leading to inflation.

National fiscal policy response to the late

2000s recession
Many nations of the world have enacted fiscal stimulus plans in response
to the global, on going recession. These nations have used different
combinations of government spending and tax cuts to boost their sagging
economies. Most of these plans are based on the Keynesian theory that
deficit spending by governments can replace some of the demand lost during
a recession and prevent the waste of economic resources idled by a lack of
demand. The International Monetary Fund has recommended that countries
implement fiscal stimulus measures equal to 2% of their GDP to help offset
the global contraction.[1]

Americas
United States
In 2008 the US Congress passed--and then-President Bush signed--a $152
million stimulus bill designed to help stave off a recession. The bill primarily
consisted of $600 tax rebates to low and middle income Americans.

The United States combined many stimulus measures into the American
Recovery and Reinvestment Act of 2009, $787 billion bill covering a variety of
expenditures from tax cuts to infrastructure investment. $184.9 billion will be
spent in 2009, and $399.4 billion will be spent in 2010 with the remainder of
the bill's appropriations spread over the rest of the decade.[2]

Asia
China
Main article: 2008 Chinese economic stimulus plan

The Chinese State Council approved a $586 billion stimulus package in

November 2008.[3]

Japan
In April 2009 Japan announced a third stimulus plan of 15.4 trillion yen
stimulus ($153 billion). This new plan includes 1.6 trillion yen investment in
low-carbon technology, 1.9 trillion yen on employment programs, and 370
billion yen for new car subsidies.[4]The legislature responded to a request
from Prime Minister Taro Aso for a stimulus that equal to 2% of GDP. Japan
has been one of the hardest hit nations during the recession and already
 [5]
experienced a lost decade when economic growth stagnated. Japan's total
stimulus amounts to 5% of its GDP.[6] Since taking office, Prime Minister Aso
has passed 25 trillion yen ($250bn) in stimulus.[7] Japan has basically
exhausted its conventional monetary policyoptions with a near zero nominal
interest rate.[8]

South Korea
South Korea 14 trillion won ($10.8bn) stimulus package in November 2008.
The November package includes 4.6 trillion won for regional infrastructure
and 3 trillion won in tax break--mainly for factory investment. South Korea's
[9]
stimulus totaled

In April 2009 South Korea enacted a "cash for clunkers" program that will give
a tax break of 2.5 million won ($1,900) to drivers who replace a car nine-
years or older with with a new car.[10] The tax break will be in effect from May
to December 2009 and is estimated to boost Hyundia sales from 530,000 to
580,000 and Kia sales from 327,000 to 357,000.[11]

South Korea's 2009 budget includes $13bn in employment stimulus including

handouts, training, and infrastructure. South Korea's total stimulus in 2008-
2009 amounts to about $69 trillion won ($52bn).[12]

Europe
European Union
Main article: 2008 European Union stimulus plan

The European Union passed a 200 billion euro plan with member countries
developing their own national plans, worth 170bn to 200bn euro in total, and
an EU-wide plan of 30bn euro coming from EU funding.[13]The European
Commission recommends that member nations' stimulus plans amount to at
least 1.2% of GDP.

Germany
Compared to other European nations, Germany is in a unique position: It has
relatively low debt, a high balance of trade, and an export driven economy.
The recession has led to a decline in German exports, but Germany has the
capacity to replace some of the export demand with domestic
stimulus.[14] The German stimulus program includes a "cash for
clunkers" program that offers rebates of $3,172 to Germans who scrap their
old cars for new, more efficient models.[15] The program totals about 1.5bn
euros.[16]

Hungary
Hungary has a high level of debt and cannot effectively raise the money
needed for deficit spending. They have unveiled a $7bn package of tax cuts
and loan guarantees directed towards buinesses, especially small and
medium sized enterprises.[17]

The Netherlands
In November 2008 the Dutch government passed a 6bn euro plan that mainly
consisted of tax breaks for businesses that made larger investments and
hired short-term workers. The package also included a new program to help
find work for the unemployed,[18] and faster public sector investment.[13] In
January 2009 the Dutch added a variety of guarantees to help ensure and
encourage exports, corporate loans, and home and hospital construction.[13]

United Kingdom
The United Kingdom has been one of the major economies leading calls for
fiscal action to stimulate aggregate demand. Throughout 2008 a number of
fiscal measures were introduced including a £145 tax cut for basic rate
(below £34,800 pa earnings) tax payers, a temporary 2.5% cut in Value
Added Tax (Sales Tax), £3 billion worth of investment spending brought
forward from 2010 and a variety of other measures such as a £20 billion
Small Enterprise Loan Guarantee Scheme[19]. The total cost of these
measures, mostly announced in the November 2008 Pre-Budget Report was
roughly £20 billion (not counting loan guarantees)[20]. Further limited
measures worth £5 billion were unveiled in the 2009 budget including
training help for the young unemployed and a "car scrappage" scheme which
offered £2,000 in subsidy for a new car purchase for the scrapping of a car
more than 10 years old (similar to schemes in Germany and France).[21]

Despite entering the crisis with a low level of public debt (roughly 40% of
GDP) and a moderate deficit compared to many European nations, the UK has
been limited in its ability to take discretionary fiscal action by the significant
burden that bank bail-outs have had on public finances. This has contributed
to a significant rise in the deficit to an estimated £175 billion (12.4% of GDP)
in 2009-10 and a rise in the national debt above 80% of GDP at its peak[22].
Furthermore, the UK has significant automatic stabilisers which have
contributed far more than discretionary action and more than most other
countries[23]. As a result, further discretionary fiscal action is unlikely.

Oceania
Australia
In February 2009 Australia debuted a $27 billion (A$47bn) stimulus package.
The package includes A$29bn ($18.85bn) for infrastructure projects such as
public housing and school construction, and A$13bn ($8.45bn) in cash
handouts to low to middle-income groups. This package follows a A$10.4bn
($6.76bn) October 2008 stimulus of cash payments to low and middle income
Australians.[24]

Advisers - Fiscal Policy

Fiscal policy is the use of government expenditure and taxation to
manage the economy. The main changes in fiscal policy happen once a
year in the Budget. It is in the Budget that the Chancellor sets the levels
of taxation and government expenditure for the next fiscal year . The
fiscal year runs from 6th April one year until 5th April the following year.
This is why the budget is usually in March. The changes in it come
generally into effect in the following month. In the Virtual Economy life is
a lot easier - you can make changes any time you like! Just use the link
to the model in the top navigation bar or on the 4th floor in the side bar to
get there from anywhere in the Virtual Economy. General
Fiscal Policy
- Reflationary
Fiscal policy can be used in various different ways. It may be used to try - Deflationary
to boost the level of economic activity when the economy is flagging a - Supply-side
little. In this case it is called reflationary policy . Alternatively the Monetary Policy
economy may be doing a little too well and in need of slowing down. In
this case deflationary policy is called for. The final use for fiscal policy
is as a tool of supply-side policy .

The rest of the pages in this section go into more detail on each of these
policies. To access them, use the links below, on the right-hand side or at
the foot of the page:

• Reflationary fiscal policy

• Deflationary fiscal policy
• Fiscal policy as a supply-side tool

To help imagine how these policies work think of the economy as a

balloon. The air in the balloon is the level of demand or economic activity.
If the balloon is a little low and short of air you want to reflate it, but if it is
over-expanded and in danger of bursting then you deflate it. The same is
true of the economy, though when it is over-expanded instead of bursting
we get other problems such as higher inflation and a larger balance of
payments deficit. Supply-side policies are then policies that manage the
capacity of the balloon; making it bigger so it can take more air or making
the balloon material more stretchy so it can expand further and so on.

Fiscal Policy - Reflationary Fiscal Policy

Governments may choose to use reflationary fiscal policy in times of recession or a general
downturn in economic activity. In this situation they will use their fiscal policy to give a boost to the
economy. They may do this by lowering taxes in some form or by increasing the level of
government expenditure. This will encourage people to spend more. If they lower indirect taxes
then this will lower the prices of the taxed goods and encourage more demand. Alternatively
they could lowerdirect taxes . This will raise people's disposable income (their take-home pay)
and therefore encourage them to spend more. Either way the level of demand in the economy
should rise and help encourage economic growth.

Reflationary fiscal policies could therefore include:

• Cutting the lower, basic or higher rates of tax

• Increasing the level of personal allowances (see the income taxexplanation for more
details on these)
• Increasing the level of government expenditure

Why not try some of these policies on the Virtual Economy? Click on the 4th floor on the side bar
or on the link at the top of the page to access the model and try these policies. Try any of them
and see the effect they have on the level of economic growth, unemployment and inflation. You
should find growth increasing, unemployment falling and inflation rising (after a time-lag perhaps).

Fiscal Policy - Deflationary Fiscal Policy

Deflationary fiscal policy is likely to be most appropriate in times of economic boom. If the
economy is growing at above its capacity this is likely to cause inflation and balance of payments
problems. To try to slow the economy down the government could either raise taxes in some form
or perhaps reduce government expenditure. Either of these will reduce the level of demand in the
economy and therefore the level of economic growth. It may increase indirect taxes which will
raise prices and deter people from spending so much, or it may increasedirect taxes , which will
leave people with less money in their pockets and so stop them from spending so much.

Deflationary fiscal policies could therefore include:

• Increasing the lower, basic or higher rates of tax

• Reducing the level of personal allowances (see the income taxexplanation for more
details on these)
• Reducing the level of government expenditure

Why not try some of these policies on the Virtual Economy? Click on the 4th floor on the side bar
or on the link at the top of the page to access the model and try these policies. Try any of them
and see the effect they have on the level of economic growth, unemployment and inflation. You
should find growth reducing, unemployment increasing and inflation falling (after a time-lag
perhaps).

Fiscal Policy - Fiscal Policy as a Supply-side Tool

Supply-side policies are policies that aim to increase the capacity of the economy to produce.
Fiscal policy usually acts on the level of demand in the economy and the deflationary and
reflationary policies on pages 2 & 3 are often known as demand-side policies . However, it is
also possible for fiscal policy to act on the level of supply as well.

Income tax will always have an effect on people's incentives to work. This will be true at most
income levels. If income tax at low income levels is too high, people may choose not to work but
to remain on benefits instead. If income tax on high levels of income is too high, people may
choose not to work so hard and take risks. Ultimately they may even choose to leave the country
if taxes elsewhere are much lower (a "brain drain").

Supply-side fiscal policies could therefore include:

• Cutting the lower and basic rates of tax to open up the gap between earnings in and out
of work and ensure people have an incentive to work
• Increasing the level of personal allowances for the same reason
• Reducing the top rate of tax to encourage enterprise, risk-taking and the incentive to work
hard

Why not try some of these policies on the Virtual Economy? Click on the 4th floor on the side bar
or on the link at the top of the page to access the model and try these policies. Try any of them
and see the effect they have on economic growth and unemployment. When you cut taxes
ensure you cut government expenditure by an equivalent amount. This ensures that your policies
have no overall impact on demand. In this way you isolate out the supply-side impact of your
policies. You should see an overall increase in economic growth over time as your policies begin
to take effect.

Criticisms of Fiscal Policy

 A Level    A Level Essays
Revision Guide

Fiscal Policy is the use of Government spending and taxation to influence the level of 
economic activity. In theory, fiscal policy can be used to prevent inflation and avoid 
recession. But, in practise there are many limitations of using fiscal policy. Fiscal 
Policy explained

Evaluation / Criticism of Fiscal Policy

1. Disincentives of Tax Cuts. Increasing Taxes to reduce AD may cause 
disincentives to work, if this occurs there will be a fall in productivity and AS 
could fall. However higher taxes do not necessarily reduce incentives to work 
if the income effect dominates.

2. Side Effects on Public Spending. Reduced govt spending to Increase AD 
could adversely effect public services such as public transport and education 
causing market failure and social inefficiency.

3. Poor Information Fiscal policy will suffer if the govt has poor information. 
E.g.  If the govt believes there is going to be a recession, they will increase 
AD, however if this forecast was wrong and the economy grew too fast, the 
govt action would cause inflation.

4. Time Lags. If the govt plans to increase spending this can take along time to 
filter into the economy and it may be too late.Spending plans are only set 
once a year. There is also a delay in implementing any changes to spending 
patterns.

5. Budget Deficit Expansionary fiscal policy (cutting taxes and increasing G) 
will cause an increase in the budget deficit which has many adverse 
effects.Higher budget deficit will require higher taxes in the future and may 
cause crowding out (see below

6. Other Componenets of AD. If the governmentt uses fiscal policy its 
effectiveness will also depend upon the other components of AD, for example 
if consumer confidence is very low, reducing taxes may not lead to an 
increase in consumer spending.

7. Depends on Multiplier And change in injections may be increased by the 
multiplier effect, therefore the size of the multiplier will be significant.
 8. Crowding Out Increased Govt spending (G) to increased AD may cause 
“Crowding out” Crowding out occurs when increased government  spending 
results in decreasing the size of the private sector.

• For example if the govt increase spending it will have to increase taxes or sell 
bonds and borrow money, both method reduce private consumption or 
investment. If this occurs AD will not increase or increase only very slowly.
• Also Classical economists argue that the govt is more inefficient in spending 
money than the private sector therefore there will be a decline in economic 
welfare
• Increased government borrowing can also put upward pressure on interest 
rates. To borrow more money the interest rate on bonds may have to rise, 
causing slower growth in the rest of the economy.

9. Monetarist Critique. Monetarists argue that in the LR AS is inelastic therefore 
an increase in AD will only cause inflation to increase

Essays on Fiscal Policy

•  Will the US economy benefit from Tax cuts 
•  Problems of Recovering from Recessions 
•  Discuss difficulties of controlling inflation 

 A Level    A Level Essays
Revision Guide

Definition of Fiscal Policy. Fiscal policy involves the Government changing the 
levels of Taxation and Govt Spending in order to influence Aggregate Demand (AD) 
and therefore the level of economic activity.
 • AD is the total level of planned expenditure in an economy (AD = C+ I + G + X 
– M)

The purpose of Fiscal Policy:

• Reduce the rate of inflation, (UK government has a target of 2%)
• Stimulate economic growth in a period of a recession.
• Basically, fiscal policy aims to stabilise economic growth, avoiding the boom 
and bust economic cycle.

Fiscal Stance:

• This refers to whether the govt is increasing AD or decreasing AD

Expansionary (or loose) Fiscal Policy.

• This involves increasing AD,
• Therefore the govt will increase spending (G)
 and cut taxes. Lower taxes will increase consumers spending because they 
have more disposable income(C)
• This will worsen the govt budget deficit

Deflationary (or tight) Fiscal Policy

• This involves decreasing AD
• Therefore the govt will cut govt spending (G)
• And or increase taxes. Higher taxes will reduce consumer spending (C)      
This will lead to an improvement in the government budget deficit

Fine Tuning : This involves maintaining a steady rate of economic growth through 
using fiscal policy. However this has proved quite difficult to achieve precisely.

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.
• In a recession the opposite will occur with tax revenue falling but increased 
government spending on benefits, this will help increase AD
Discretionary Fiscal Stabilisers

• This is a deliberate attempt by the govt to affect AD and stabilise the 
economy, e.g. in a boom the govt will increase taxes to reduce inflation

• Injections (J):             This is an increase of expenditure into the circular flow, 
it
 includes govt spending(G), Exports (X) and Investment (I)
• 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)

• Note Fiscal Policy was particularly used in the 50s and 60s to stabilise 
economic cycles. These policies were broadly referred to as 'Keynesian' In 
the 1970s and 80s governments tended to prefer monetary policy for 
influencing the economy.
• There are many factors which make successful implementation of fiscal Policy 
difficult. See:Evaluation of fiscal policy