A) The main influences on government expenditure:
Government Spending – Spending by the central and local government on goods and services, such as Healthcare and Education.
The trade cycle
The X axis on the economic cycle graph represents time and the Y axis represents real GDP. From these two indicators, we are able to see the state of the economy over a certain period of time by looking at this graph. The straight diagonal line is called the trend growth rate and is the predicated rate of GDP. However, due to unforeseen events such as supply side shocks happening regularly, the reality is that the actual growth rate differs quite a lot from the trend growth. Although this is the case, the overall trend of actual growth and trend growth is the same. Instead of a straight diagonal line, the actual growth contains a number of peaks and troughs. When the actual GDP rate is higher than the predicated GDP rate, there is a positive output gap, However, when the actual GDP rate is lower than the predicated GDP rate, there is a negative output gap. The fluctuations of the economic cycle can be described by one of four terms. A peak in the economic cycle can be described as a boom. This is a period of high levels of output within the economy. The characteristics of a boom often include high levels of productivity, increased business sales/demand for goods/services, increasing wages and a relatively high inflation rate. After a boom a slowdown occurs, this is when the rate of GDP starts to fall. The trough in the economic cycle represents a recession. This is defined as a decline in GDP over two of more consecutive quarters. In this stage of the economic cycle, high levels of unemployment, low consumer and business confidence, and a reduction in Aggregate demand are all likely to occur. Once the rate of GDP starts to increase again, the economy goes into the recovery phase. This can often be characterised by low levels of economic growth, a reduction in unemployment and increasing consumer and business confidence. It could be argued that the UK is still currently in the recovery stage from the 2008 financial crisis.
Fiscal policy is a demand side policy and is defined as changes in government spending or taxation by the government in order to influence the level of AD within the economy. There are two types of fiscal policy: Discretionary (Fiscal policy that is implemented through policy changes/government action) or automatic stabilisers (Policies used to offset fluctuations in the economic cycle that do not require government intervention/regular policy change). Fiscal policy can either be contractionary (Used to reduce AD e.g. an increase in income tax) or expansionary (Used to increase AD e.g. a reduction in corporation tax). Expansionary policy is often used in times of economic downturn, whereas contractionary fiscal policy is often used in times of economic prosperity. For example, from 2008 to 2011 UK government spending had increased by around £150BN in order to help the UK economy to recover from the 2008 financial crisis.
This is a feature of the tax system that is put in place by the government that helps to reduce the severity of the fluctuations in the economic cycle. As the fiscal policy is automatic, it does not need to be constantly changed by the government. For example, during a recession the unemployment rate is likely to increase considerably. Countries with a welfare system such as the UK will then have to increase their spending on welfare payments in order to compensate for the increased levels of unemployment. Therefore the level of government spending will automatically increase as there is an active welfare system that has been put in place. In addition to this, the increase in unemployment will cause a reduction in the number of people that are paying income tax. This is because only those who work have to pay income tax. Furthermore, during times of recession, businesses often experience a reduction in sales and profit. This means that businesses won’t be paying as much corporation tax as a result of their reduced profits. The reduction in those paying income tax and the amount of corporation tax paid by businesses can be categorised under expansionary fiscal policy, thus helping to reduce the severity of the recession. This can be shown on the following diagram.
During a recession an economy has large amounts of spare capacity as a result of a reduction in AD. The diagram shows what the economy is likely to look like once the reduction in AD has taken place. Automatic stabilisers act as expansionary fiscal policy causing an increase in AD1 to AD2. This reduces the impact that the recession has on the economy. As real GDP increases from Y1 to Y2, the level of spare capacity decreases. Although there is still a relatively large amount of spare capacity within the economy, the automatic stabilisers have reduce the amount by Y1 to Y2, thus reducing the severity of the recession. This is down to the increase in government spending and the reduction in those paying income tax and businesses paying corporation tax. Instead of those unemployed receiving no stable income, they are now receiving welfare benefit which increases consumer consumption (compared to if they received no welfare benefits). Overall, this leads to an increase in Real GDP (reducing the severity of the recession) as a well as an increase in the general price level (helping to reduce the problem of low inflation/deflation that often takes place during recessions, a link which can be shown on the Phillips curve).
In contrast to this, during a boom unemployment decreases resulting in a reduction in the amount of people claiming benefits. Therefore, government spending on welfare automatically drops. Furthermore, a decrease in unemployment means more people are working and therefore more people are paying income tax. In addition to this, during a boom the demand for goods/services is likely to be higher, thus increasing businesses revenue and profit.