(2023) A Level H2 Econs Essay Q6 Suggested Answer by Mr Eugene Toh (A Level Economics Tutor)
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6a.
Explain how expansionary fiscal policy works
Expansionary fiscal policy, a key tool in macroeconomic management, involves either increasing government spending or decreasing taxes to stimulate economic activity. The aim is to boost aggregate demand (AD), which is the total demand for goods and services within an economy.
The government can increase its spending in various forms, such as infrastructural projects or increased spending on public services, or direct hiring. Since AD = C+I+G+(X-M), AD increases, resulting in a multiplied increase in real national incomes and thus higher economic growth.
The government can also reduce taxes. A decrease in personal income taxes boosts disposable income, leading to higher consumer spending (C). Reduced corporate taxes encourage businesses to invest more (I), as they have higher after-tax profits. Both these actions increase AD, resulting in a multiplied increase in real national incomes and thus higher economic growth.
With higher real national output, firms increase hiring to produce a higher level of output, reducing cyclical unemployment
Undesirable consequence: Demand-pull inflation
One of the critical challenges associated with expansionary fiscal policy is the presence of time lags. These lags can significantly delay the policy's impact on the economy. For instance, when a government increases its spending or cuts taxes to stimulate economic growth, the intended positive effects on employment and output may not materialize immediately. This delay is partly due to the time required for policy decisions to be implemented and for their effects to permeate through the economy. As a result, by the time these policies take effect, the economy might have already embarked on a natural recovery. This scenario is particularly problematic if the economy is operating near its full employment level, as further stimulation can push it into the intermediate range of the Aggregate Supply (AS) curve, leading to heightened demand-pull inflation.
This phenomenon was notably evident in the US economy during 2021 and 2022. In response to economic downturns, expansionary fiscal policies were adopted, involving substantial government spending and tax cuts. However, the timing of these measures coincided with the economy's natural recovery phase, leading to an overstimulation of demand. Consequently, the US witnessed a notable rise in inflation rates, with the inflation rate climbing from approximately 4.70% in 2021 to about 7.57% in 2022. This surge in inflation underscores the risks associated with expansionary fiscal policy, especially when implemented without careful consideration of the economy's existing trajectory and the potential lag in policy effectiveness.
Undesirable consequence: High debt / higher interest repayments
Another significant downside of expansionary fiscal policy is the potential accumulation of high public debt. When governments engage in increased spending or reduce taxes to stimulate economic growth, they often need to borrow funds to finance these activities, especially if existing revenues are insufficient. This borrowing adds to the national debt, which can grow to unsustainable levels over time. The accumulation of large public debts imposes a heavy burden on future generations, who will be responsible for servicing this debt. Additionally, it can limit the government's ability to respond to future economic crises, as a significant portion of government revenues may need to be diverted towards servicing existing debt rather than funding essential services or new initiatives.
The burden of high public debt becomes even more evident when considering the associated interest payments. As the debt grows, so does the cost of servicing it, in the form of interest payments. These payments can consume a substantial portion of government budgets, further restricting fiscal flexibility. For instance, countries with high levels of public debt often find a significant share of their annual budgets dedicated to interest payments, reducing the funds available for public investment, social services, and other developmental activities. This situation can lead to a vicious cycle, where governments need to borrow more to meet their spending requirements, exacerbating the debt problem. Moreover, high public debt levels can lead to increased borrowing costs, as lenders may demand higher interest rates to compensate for the perceived higher risk, adding further strain to government finances.
6b.
Introduction
Expansionary supply side policies are expansionary fiscal policies that also target improving the supply side potential of the economy. Governments aim to achieve full employment, price stability, sustained economic growth & healthy balance of trade.
How expansionary supply-side policies can be effective in achieving macroeconomic policy aims
An illustrative example of expansionary supply-side policy is the government's increased investment in building universities. Since AD = C+I+G+(X-M), an increase in Government expenditure will result in an increase in aggregate demand. This thus result in a multiplied increase in real national income, increasing economic growth. As firms hire more factor inputs including labour, there will be a fall in cyclical unemployment.
However, the long-term impacts of this policy extend far beyond the initial construction phase. Once the universities are operational, they contribute to the development of a more skilled and educated labor force. This augmentation in human capital is pivotal in increasing the economy's productive capacity, effectively shifting the long-run aggregate supply (LRAS) curve to the right. The rightward shift in LRAS is instrumental in lowering demand-pull inflation as the economy can now produce more goods and services at each price level.
Furthermore, a more educated and skilled workforce enhances productivity, reducing production costs. This cost reduction has a cascading effect on the international front, making exports more competitively priced, thereby improving the balance of trade.
However, given that expansionary supply-side policies typically are policies that target long-term economic growth, they are not ideal or effective in addressing acute problems that the economy may face (e.g. sudden sharp increases in unemployment / recession due to the pandemic or higher inflation due to the Russia-Ukraine war)
Other policies may be more effective in addressing short term changes in the economy
In addressing sudden, acute economic challenges, such as a sharp rise in unemployment or a recession triggered by unforeseen events like a pandemic, expansionary supply-side policies may not be immediately effective. In such scenarios, the economy may require more direct and swift measures. For instance, increasing government expenditure is a powerful tool to stimulate economic activity during a recession. This approach helps avoid negative outcomes like prolonged unemployment and declining consumer and business confidence.
When the government directly injects funds into the economy, perhaps through public works projects or increased social welfare spending, it immediately boosts aggregate demand (AD). This direct stimulation is crucial during a recession, where private sector demand is weak. Government spending provides an immediate demand for goods and services, leading to increased production, which in turn can stem the tide of rising unemployment. This approach can be more effective than supply-side policies in the short term, as the latter often take longer to impact the economy due to their focus on gradually improving the supply capacity.
Moreover, in the context of imported inflation, a different kind of intervention, such as an appreciation policy, can be more appropriate. By allowing the domestic currency to appreciate, imported goods and services become cheaper, which helps to mitigate the impact of imported inflation. This strategy can be particularly effective in small, open economies that rely heavily on imports. However, it is important to balance this approach with the potential negative impact on exports, as an appreciated currency can make domestic goods more expensive in foreign markets.
Hence, while expansionary supply-side policies have their merits in achieving long-term macroeconomic goals, they might not always be the most effective in dealing with immediate crises or specific issues like imported inflation. Direct government intervention through increased spending or targeted monetary policies may offer more immediate relief in such situations.
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