Answers may include:

Definition

• Circular flow of income: The model that shows the movement of income between households and firms in an economy, illustrating how economic activity is connected through the exchange of goods and services as well as factor payments.
• Rate of interest: The cost of borrowing money or the return on saving; it influences consumer and producer decisions regarding spending, saving, and investment.
• Leakages and injections: Leakages are the portions of income not spent on domestic output (savings, taxes, imports), while injections are additions to the circular flow that stimulate economic activity (investment, government spending, exports).

Explanation / Economic Theory

• A decrease in the rate of interest generally reduces the incentive to save (a leakage) and increases the incentive to borrow for both consumption and investment.
• When savings decrease, households have more disposable income to spend. This implies a higher level of consumption, raising aggregate demand.
• Firms respond to lower borrowing costs by investing more in capital goods. Higher investment acts as an injection into the circular flow, further increasing output.
• As injections (investment) rise relative to leakages (savings), the overall national income (GDP) expands.
• The multiplier effect amplifies the initial increase in injections. Additional spending by firms on capital goods creates new income for households supplying factors of production. This income is then re-spent, increasing aggregate demand multiple times throughout the economy.
• Higher consumption and investment expand the size of the circular flow, leading to greater output and employment.
• Over time, this can lead to sustained economic growth if the increase in investment contributes to an expanded productive capacity.

Diagram

Conclusion

• By lowering the rate of interest, the balance between leakages and injections shifts in favor of injections, leading to an expansion in the circular flow of income and therefore an increase in the size of the economy.

Answers may include:

Definition

• Fiscal policy: Government use of taxation and government expenditure to influence aggregate demand and overall economic activity.
• Long-term economic expansion (long-term economic growth): Sustained increase in an economy’s productive capacity, often measured by a rightward shift of the long-run aggregate supply (LRAS) curve or a rise in potential output over time.
• Multiplier effect: The process by which an increase (or decrease) in an injection (government spending) leads to a proportionately larger change in national income.

Explanation/Economic Theory

• Fiscal policy aims to manage aggregate demand (AD) through variations in government spending (G) and taxation (T).
  • Expansionary fiscal policy: Involves increased government spending or reduced taxes to shift AD to the right, potentially boosting real output (Y) and employment.
• In the short run, an increase in government spending raises AD from AD₁ to AD₂.
  • This can lead to higher real output (movement from Y₁ to Y₂) and a higher price level (P₁ to P₂).
  • The initial injection of spending creates further rounds of spending due to the multiplier effect.
• Supply side effects of fiscal policy
• Over the long run, fiscal policy can contribute to economic growth if funds are allocated to:
  • Infrastructure (e.g., building roads, schools, hospitals), which enhances productivity.
  • Research and development and human capital formation, which shift the long-run aggregate supply (LRAS) rightward.
• However, there are potential drawbacks:
  • Crowding out: If government borrowing raises interest rates, private investment might be discouraged, limiting long-term growth.
  • Budget deficits and public debt: Persistent expansionary fiscal policy can increase national debt, possibly leading to higher future taxes or reduced spending, offsetting the long-term benefits.
  • Inflationary pressures: If the economy is already near or at full employment, additional demand-side stimulus can push up the general price level.

Diagram
Expansionary fiscal policy where AD moves right (AD/AS diagram).

• Keynesian or Neo-classical diagrams accepted.

• Supply side effects of expansionary fiscal policy

Evaluation

• Short-run vs. long-run effects

  • Short-run positive: Boosts AD, reducing unemployment, increasing output.
  • Short-run negative: Might cause inflationary pressures if near capacity, and budget deficits can rise quickly.
  • Long-run positive: Productive infrastructure spending can enhance potential output and living standards.
  • Long-run negative: Large debt accumulation can force higher taxes or lower government spending in the future, hindering growth.

• Real-world examples

  1. United States (2009 American Recovery and Reinvestment Act)

     • Approximately USD 787 billion allocated to infrastructure, education, and healthcare post-Global Financial Crisis.
     • Growth averaged around 2.8% between 2010 and 2012, highlighting a recovery in output and employment.
     • Public debt rose significantly, indicating possible crowding out concerns for future investments.

  2. Japan (Early 2000s to 2010s)

     • Multiple fiscal stimulus packages used to combat deflation and stagnation.
     • Large-scale infrastructure projects provided short-term boosts to GDP.
     • Persistent high debt-to-GDP ratio (exceeding 200% after 2010) raised concerns over sustainability, limiting scope for further expansionary measures.

  3. Germany (Post-2008 stimulus and ‘Energiewende’ investment)

     • Increased government spending on renewable energy and environmental initiatives.
     • Contributed to steady growth and lower unemployment, with unemployment rates falling below 6% by 2015.
     • Critics highlight high electricity costs and the need for continuous public support, pointing to potential efficiency issues.

Conclusion

• Fiscal policy can be effective for achieving long-term economic expansion if it is well-targeted toward productivity-enhancing expenditures.
• Long-term effectiveness depends on managing debt levels and avoiding crowding out of private investment.
• To provide even further long term economic growth, supply side policies can be used with fiscal policies.
• Real-world data indicate that while fiscal stimulus can help economies recover and expand, careful balancing of deficits and prioritization of spending are crucial for sustainable growth.