Fiscal policy

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    Fiscal policy

    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.
    • The distribution of income.

    How fiscal policy work

    High rate of inflation

    High rate of inflation is caused by too much aggregate demand in the economy. Government will use deflationary fiscal policy. Government will try to influence aggregate demand by reducing its public spending. The government will spend less on construction of roads, bridges and other public spending and thus aggregate demand will fall. On the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable income out people’s pocket resulting in a lower demand.

    Low rate of inflation

    In an economic recession, aggregate demand, output and employment all tend to fall. Now the Government wants to increase employment in the economy, it can attempt to do so by increasing aggregate demand. The Government will increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so that people have more disposable income to spend and instigate demand in the economy.

    Role of fiscal policies

    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.
    • The distribution of income.

     

    AD=C+G+I+(X-M)

     

    As we can see in the above equation that G (Government Expenditure) is a component of AD, it can be used by Government to influence AD in the economy. The government can use expansionary or deflationary fiscal policy to get the desired results. Let’s discuss each policy in detail.

    Expansionary fiscal policy

    Expansionary fiscal policy is used to increase the Aggregate demand in the economy. If the economy is having a deflationary gap, the government can use expansionary fiscal policy to reduce the gap or totally eliminate it.

    Deflationary gap

    Deflationary gap is the difference between full level of employment and the actual level of output of the economy. We can see in the diagram below, that the economy is operating a level ‘a’ below the Yf (full level of employment).

    The consequence is that due to deflationary gap all the resources of the economy are not being used in the optimum level and they are idle. This results in unemployment and low level of output. This is not desirable for any government. In order to reduce/eliminate the deflationary gap, the government uses expansionary fiscal policy.

     

    Government will either increase its spending or reduce taxes (or both) in order to stimulate the aggregate demand. Increase Government spending will result me more projects being funded by the government and thus employment and output will increase. Even a lower tax rate will result in more disposable income for households and encourage consumption.

    Increased G and will lead to higher AD. However, this might also lead to higher prices/inflation in the economy.

    Contractionary fiscal policy

    Contractionary fiscal policy involves the reduction of government spending and increase taxes as a measure to control inflation/AD in the economy. With reduced government spending, the AD will fall and thus reduce pressure on the economic resources and the average price level in the economy will come down. Similarly, increased taxes will take away the excess disposable income from the households and result in a fall in AD. Contractionary fiscal policy is thus used to reduce the inflationary gap.

    Inflationary gap

    Inflationary gap is when the Aggregate demand exceeds the productive potential of the economy. As we can see through the diagram, the economy is operating at a level above the full employment level of the output. Due the limitation of the economy to fulfil this increased demand the average price level in the economy increases resulting in inflation.

    Problems of fiscal policy

    Reduce incentive to work

    Raising taxes on income and profits reduce work incentives, employment and economic growth. An effort to reduce aggregate demand may cause disincentives to work, if this occurs there will be a fall in productivity and Aggregate supply could fall.

    Adverse effect of lowering Public Spending

    Reduced government spending to Increase Aggregate demand could adversely affect public services such as public transport and education causing market failure and social inefficiency.

    ‘Crowding out’ effect

    With an increase in government expenditure, there will be greater competition for limited resources. This will offset private investments resulting in shrinking of the private sector.

    Inaccurate forecasting

    If the Government’s estimate or forecasting is wrong or inaccurate the fiscal policy will suffer. For example, if a recession is expected and the government practices deficit budget, and yet the recession turns out to be a boom, this will cause inflation.

    Implementation of the Policy

    Planning for the spending is done once by most of the governments. If there is a delay in the implementation of the fiscal policy, it might reduce the effectiveness of the policy. Thus the time lag is important.

    Poor Information

    Fiscal policy will suffer if the government has poor information. e.g.  If the government believes there is going to be a recession, they will increase AD, however if this forecast was wrong and the economy grew too fast, the government action would cause inflation.

    Time Lags

    If the government plans to increase spending this can take a long time to filter into the economy and it may be too late. Spending plans are only set once a year. There is also a delay in implementing any changes to spending patterns.

    Budget Deficit

    Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget deficit which has many adverse effects. Higher budget deficit will require higher taxes in the future and may cause crowding out (see below

    Other Components of AD

    If the government uses fiscal policy its effectiveness will also depend upon the other components of AD, for example if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending.

    Depends on Multiplier

    Change in injections may be increased by the multiplier effect; therefore the size of the multiplier will be significant.

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