Fiscal Policy

• • [ edit] • project Fiscal policy refers to the federal government's use of its annual budget (usually 'handed down' in May each year) to affect the level of economic activity, resource allocation and income distribution. The budget strategy can also influence the achievement of the government's objectives of internal and external balance and economic growth. The two main instruments of fiscal policy are government spending and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

- Aggregate demand and the level of economic activity;

- The pattern of resource allocation; and

- The distribution of income.

The Stances of Fiscal Policy

The stance of fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:

- A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

- An expansionary stance of fiscal policy involves a net increase in government spending (G > T) through a rise in government spending or a fall in taxation revenue or a combination of the two. This will lead to a larger budget deficit deficit or a smaller budget surplus than the government previously had a balanced budget. Expansionary fiscal policy will lead to an increase in economic activity. Expansionary fiscal policy is usually associated with a budget deficit.

- Contractionary fiscal policy (G < T) occurs when net government spending is reduced either through higher taxation revenue or reduced government spending or a combination of the two. This would lead to a lower budget deficit or a larger surplus than the government previously had, or a surplus if the government previously had a balanced budget. Contractionary fiscal policy is usually associated with a surplus.

Methods of raising funds

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

Taxation
Seignorage, the benefit from printing money
Borrowing money from the population,resulting in a fiscal deficit.

Funding of deficits

A fiscal deficit is often funded by issuing bonds, like Treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too great, a nation may default on its debts, usually to foreign debtors.

Economic effects of fiscal policy

Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth.

Keynesian economics suggest that adjusting government spending and tax rates, are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be repaid for by an expanded economy during the boom that would follow, the basis for the New Deal.

During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian Theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.

Despite the importance of fiscal policy, a paradox exists. In the case of a government running a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a higher aggregate demand (AD) due to the lack of disposable income, contrary to the objective of a budget deficit. This concept is called crowding out. Alternatively, governments may increase government spending by funding major construction projects. This can also cause crowding out because of the lost opportunity for a private investor to undertake the same project. However, the effects of crowding out are usually not as large as the increase in GDP stemming from increased government spending.

Another problem is the time lag between the implementation of the policy, and visible effects seen in the economy. It is often contended that when an expansionary Fiscal policy is implemented, by way of decrease in taxes, or increased consumption (keeping taxes at old level), it leads to increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead to inflation. Hence, checks need to be kept in place.

External links

US - External Debt viz Savings rate Comparing External debt viz Savings rate - since 1995 (which are two of the components that finances the Fiscal Policy )

Fiscal Policy is an additional method to determine public revenue and public expenditure.

References

Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002): The Economic Way of Thinking (10th ed). Prentice Hall.

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