As part of your IBDP economics curriculum, you will be expected to use real world examples to illustrate economic concepts and theories, particularly in the context of policy. This helps to demonstrate a practical understanding of the material and its relevance to the world around us. This article will discuss how to incorporate two real-world examples of fiscal policy when answering an exam-style question.

Expansionary Fiscal Policy – American Recovery and Reinvestment Act (2009)

The United States government enacted the American Recovery and Reinvestment Act (2009) to address the Great Recession. The stimulus package comprised of a combination of measures, including tax cuts, infrastructure expenditure, and increased unemployment benefits through transfer payments.

Exam-style Question

Question:

Discuss why, in contrast to the monetarist/new classical model, an economy
can remain stuck in a deflationary (recessionary) gap according to the
Keynesian model.

Answer:

The monetarist/new classical model argues that an economy will always tend towards full employment in the long run, with wages and prices being flexible and responding to changes in supply and demand. In contrast, the Keynesian model suggests that an economy can remain stuck in a deflationary or recessionary gap, even in the presence of low interest rates and flexible prices, due to a lack of aggregate demand.

A deflationary or recessionary gap refers to a situation where the actual output of an economy is below its potential output. This can occur due to a decline in aggregate demand, resulting in decreased economic activity and high levels of unemployment.

According to the Keynesian model, deflationary gaps can persist due to the inability of wages and prices to fall, which can lead to a situation where demand remains low and the economy remains stuck in a recessionary state. In addition, the Keynesian model assumes that the aggregate supply curve has a long, horizontal section, which means that equilibrium GDP is lower than potential GDP.

During the Great Recession of 2007-2008, the United States faced a significant decline in aggregate demand, resulting in a recessionary gap. The traditional monetarist/new classical approach of relying solely on monetary policy, such as adjusting interest rates, proved insufficient to stimulate economic growth.

In response the US government enacted the American Recovery and Reinvestment Act (2009) to address the recessionary gap. The stimulus package comprised of a combination of measures, including tax cuts, infrastructure expenditure, and increased unemployment benefits through transfer payments. The Keynesian approach of using expansionary fiscal policy, as demonstrated by the stimulus package, proved to be effective in addressing the recessionary gap.

Contractionary Fiscal Policy – United Kingdom Government Austerity Programme (2010-2019)

The United Kingdom Government Austerity Programme (2010-2019) aimed at reducing the government budget deficit and limiting the role of the welfare state. The programme involved sustained reductions in public spending and tax rises, which resulted in over £30 billion in spending reductions to welfare payments, housing subsidies, and social services between 2010 and 2019.

Exam-style Question

Question

Explain and evaluate the effectiveness of policies designed to reduce a national deficit and avoid a debt trap.

Answer

To reduce a national deficit and avoid a debt trap, policymakers have various policy tools at their disposal. One approach is to implement contractionary fiscal policies, such as reducing government spending and increasing taxation. For example, United Kingdom Government Austerity Programme which was introduced in 2010 to reduce government deficits through sustained reductions in public spending and tax rises. Between 2010 to 2019 the government made spending reductions of over £30 billion to welfare payments, housing subsidies, and social services.

One of the main benefits of the programme was that it helped to restore confidence in the UK’s fiscal stability and prevented a potential debt crisis. By reducing the budget deficit, the government was able to lower its borrowing costs, which in turn made it easier for the government to fund public services and investments in the future.

However, contractionary fiscal policies can have potential negative consequences, such as reduced economic growth, and increases in inequality and unemployment. For instance, cutting government spending in essential areas such as education and healthcare could affect vulnerable groups disproportionately. Additionally, increasing taxes can reduce the disposable income of households and dampen consumer spending, further slowing down the economy.

Alternatively, policymakers could opt for expansionary fiscal policies, such as increasing government spending or cutting taxes, to stimulate economic growth and reduce the debt-to-GDP ratio. This approach aims to increase demand and create jobs, which in turn can lead to higher GDP, tax revenues and lower social welfare spending. However, expansionary fiscal policies can also have negative consequences, such as higher levels of inflation and greater budget deficits.

Monetary policies, such as changing interest rates or implementing quantitative easing, can also be used to address national deficits and debt levels. By increasing the money supply the central bank reduces the cost of borrowing on new government debt and helps stimulate economic growth. However, these policies have their own challenges and limitations, such as the risk of inflation and the difficulty of achieving a balance between stimulating the economy and maintaining price stability.

In evaluating the effectiveness of policies designed to reduce a national deficit and avoid a debt trap, it is crucial to consider the specific context and needs of each country. Policymakers must carefully balance the need for fiscal sustainability with the need for continued economic growth and social welfare, and consider the potential trade-offs between short-term and long-term goals. They must also consider the distributional impacts of their policies and strive to ensure that vulnerable groups are not disproportionately affected.

Note: top scoring answers would include illustrations and explanations of AD-AS diagrams. These have not been included in the above examples for the sake of brevity and clarity, but should be added to provide a more comprehensive and thorough analysis of the topic at hand.