One way to work out multiplier is by taking the reciprocal of the mpc (1/1-mpc). The mpc is how of the income a person spends. So if they get £10 and spend £8, their mpc is 0.8.Therefore, the more income is spent, the more effective fiscal policy is as the great V is and so the greater total output is, meaning an increase in AD. The mpc is also included in the consumption function. The consumption function s C=a+b(Yd). A is the lowest amount received by a person, generally unemployment benefit. B is the mpc and Yd is disposable income. The graph below shows that if income goes up, so does consumption. However, the amount it goes up by depends on the mpc because it is what disposable income is multiplied by. So the higher the mpc, the higher people will consume. This means that C goes up in the equation written at the beginning meaning that fiscal policy has boosted AD. However, it is difficult to measure the multiplier. Therefore, together with inaccurate forecasting, fiscal policy could be misused. If the multiplier effect is too big, inflationary pressure might occur. However, if the multiplier effect is too low, then a change in AD may not be significant enough to create a difference. The extent to which these changes affect inflation, also depend on how big the output gap is to start with.
Changing government spending and taxation mainly forms fiscal policy. This is because it directly affects G in the equation. However, it is generally assumed that tax cuts are less effective than government spending. This is because not all of the tax revenue received by the government. This means the mpc will be low and so reducing the effects of mpc. Also, it is difficult to measure how firms and people would react to tax cuts. Some might be ignorant of the tax cuts and carry on as normal making few adjustments. Yet some might create long-term strategies to work around the tax cut. And so how much effect the tax cut has on the economy depends on the forecast of whether the tax cut is temporary or permanent. If it’s permanent, it is most likely going to have huge change, whereas a temporary one wouldn’t. The extent to which the effect of the tax has would also depend on which type of tax and whether it’s direct or indirect.
Fiscal policy would also have a downside to it. If high taxes were implemented, then huge consequences would occur. Higher taxes would mean that people would have a disincentive to work. This is because all of their earnings would be stripped from them so they lose the will to work. However, not all employees would do this. Some would put in more effort and longer hours in order to regain the same wage they used to receive. Again, there would be different reactions to the different lengths of the taxes. Firms would also be affected. They would be less willing to invest, as their profits would be more heavily taxed leaving them with less disposable income. This means that they would have to watch their money carefully. Again, their reaction would depend on the length of the tax rise. In both cases, a more subtle tax would induce a smaller change than a large tax. This is how the economy would be controlled between extremes.
If government spending increased unemployment benefit grew, people might stop searching, as they would find living off unemployment benefit suitable. This would mean they get free money for not doing anything. However, the law states that they can only gain the allowance if they are job seekers. So not everyone would take the option of stopping the search, as it is illegal. Also, the new working families’ tax credit means that they would not be placed in the poverty trap anymore, meaning that more would find a job as they could be a lot better off under employment.
If there is a budget deficit in the economy and the government decides to pay it back through loans from individuals and firms. It will now compete with the private sector and so will have to raise interest rates. This in turn raises private interest rates. This will then discourage firms to invest and individuals to buy on credit. This is known as crowding out because the government borrowing overshadows the private borrowing.
The extent to which the effectiveness of fiscal policy depends on is the responsiveness of the public to these changes in fiscal policy. In an economy like Japan, fiscal policy is useless as expectations are too low for it to have an effect and increase consumer spending. Therefore expectations play an important part in how effective fiscal policy is.
In conclusion, all of these factors affect the economy. However, some affect the economy more than others such as taxation is less effective than spending. Also, the effect of fiscal policy would also change depending whether the economy was in a boom or a recession. We can see this because fiscal policy would have more effect in a boom due to greater expectations and more confidence. And so overall we can see by weighing up the arguments, that fiscal policy is a powerful tool, yet it must be used in the right way. The effectiveness comes from the interaction of these two variables. If they are used to complement each other, then fiscal policy is indeed very handy. However if the opposite is true, then it can b a devastating blow to the economy in the form of deflation or inflation or loss of confidence. An important factor is also monetary policy. If monetary policy is loose, then fiscal must be very tight in order to increase the capacity of the economy substantially.
