Policies to Increase Economic Growth | A-Level Economics Model Paragraph
Expansionary fiscal policy
Expansionary fiscal policy can be used to promote economic growth. This is when the government increases spending or decreases taxes in order to influence the level of aggregate demand in the economy. One example could be the government reducing income taxes. This allows consumers to keep more of their income. As their disposable incomes rise, consumer spending (C) is likely to rise. As C is a component of aggregate demand (AD), AD will increase. As there is greater demand for goods and services from consumers, this leads to an increase in the demand for workers. So, jobs are created, which will lead to more employment and consumer spending will increase even further. As this happens, businesses get closer to full capacity, so they might increase their spending on capital, which is known as the accelerator effect. Overall, there is a multiplier effect as shown below, so there is an increase in economic growth from y1 to y3, showing an increase in economic growth.
Evaluation: the size of the multiplier
One evaluation of expansionary fiscal policy is the size of the multiplier. The multiplier is determined by the equation k = 1 / (1 - MPC). If the government lowers taxes for high-income households, the size of the multiplier is likely to be smaller, making fiscal policy less effective. If high-income households tend to have higher savings and, when their disposable income rises, are more likely to increase their savings rather than spend, aggregate demand wouldn’t rise enough to stimulate growth from a recession.
Evaluation: national debt
However, one disadvantage of implementing expansionary fiscal policy is that it causes an increase in the budget deficit. This is when government spending exceeds tax revenue. If a budget deficit persist, the country accumulates higher amounts of national debt. High debt is damaging for the UK economy because it must pay back both the debt and interest on top. For example, the UK government spent around £100 billion on interest alone last year. Those repayments carry a huge opportunity cost. A country with lower debt and lower interest could fund more spending on services like education and health care. This is why the UK government might try to avoid expansionary fiscal policy, even during a recession.
Evaluation: crowding out
Crowding out can occur when government spending is funded through high levels of borrowing. As the government borrows more to fund spending, demand for bonds from the private sector rises, reducing liquidity in the financial system. This can crowd out private investment. Therefore, as government spending increases, private investment or consumer spending decreases, leading to only a minimal effect on aggregate demand and therefore growth.
Expansionary monetary policy
One policy that can help the economy recover from a recession is expansionary monetary policy, which involves the central bank reducing interest rates. This reduces the cost of borrowing and the reward for saving, incentivising consumers and firms to borrow more and save less. For consumers, lower mortgage interest also increases their disposable incomes. Consumer spending (C) should increase. As consumers increase spending, business confidence should rise, so investment (I) by businesses should also increase as they expect to reach closer to their capacity. This is known as the accelerator effect. As these (C and I) are components of aggregate demand (AD), AD will increase. The diagram shows AD shifting to the right, leading to higher growth from Y1 to Y2, indicating recovery from a recession. This also causes the price level to rise from PL1 to PL2.
Evaluation: liquidity trap
However, expansionary monetary policy can be ineffective if the economy is experiencing a liquidity trap. This is when lower interest rates fail to stimulate economic growth because, despite the central bank reducing the base interest rate, commercial banks do not decrease their high street interest rates. This might be due to a lack of confidence in the economy. During a recession, unemployment is likely to be very high. As consumers fear losing their jobs, they may be less likely to take out loans, especially for big purchases like a home or a mortgage. Likewise, businesses are more reluctant to lend at low rates because they see more risk in the economy. As a result, borrowing does not increase and therefore the economy is unable to recover with lower interest rates alone.
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