Galang, Rose Anne G.

FINMGT2

July 26, 2012 T/TH 9:30-11:00

1. What is Fiscal Policy? Fiscal policy is the use of government spending and TAXATION to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groupsa tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are revenue neutral may be construed as fiscal policyand may affect the aggregate level of output by changing the incentives that firms or individuals facethe term fiscal policy is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them. Fiscal policy is said to be tight or contractionary when revenue is higher than spending (i.e., the government budget is in surplus) and loose or expansionary when spending is higher than revenue (i.e., the budget is in deficit). Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit. Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy. It is the sister strategy to monetary policy with which a central bank influences a nation's money supply. These two policies are used in various combinations in an effort to direct a country's economic goals. Here we take a look at how fiscal policy works, how it must be monitored and how its implementation may affect different people in an economy. Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money.

The underlying component of fiscal policy is the government's budget, which determines how much it will spend on various goods and services. The amount of the budget is usually tied to tax revenues and other sources of income for the government. In a nation with a neutral fiscal policy, the budget and the tax revenues are equal, while expansionary policies create a budget deficit, because the government is spending more than it takes in. Contractionary or tight policies, by contrast, create a surplus, as tax revenues exceed budget expenditures.

2. FUNCTIONS OF FISCAL POLICY Allocation The first major function of fiscal policy is to determine exactly how funds will be allocated. This is closely related to the issues of taxation and spending, because the allocation of funds depends upon the collection of taxes and the government using that revenue for specific purposes. The national budget determines how funds are allocated. This means that a specific amount of funds is set aside for purposes specifically laid out by the government. This has a direct economic impact on the country. Distribution Whereas allocation determines how much will be set aside and for what purpose, the distribution function of fiscal policy is to determine more specifically how those funds will be distributed throughout each segment of the economy. For instance, the government might allocate $1 billion toward social welfare programs, but $100 million could be distributed to food stamp programs, while another $250 million is distributed among low-cost housing authority agencies. Distribution provides the specific explanation of what allocation was intended for in the first place. Stabilization Stabilization is another important function of fiscal policy in that the purpose of budgeting is to provide stable economic growth. Without some restraints on spending, the economic growth of the nation could become unstable, resulting in periods of unrestrained growth and contraction. While many might frown upon governmental restraint of growth, the stock market crash of 1929 made it clear that unfettered growth could have serious consequences. The cyclical nature of the

market means that unrestrained growth cannot continue for an indefinite period. When growth periods end, they are followed by contraction in the form of recessions or prolonged recessions known as depressions. Fiscal policy is designed to anticipate and mitigate the effects of such economic lulls. Development The fourth major function of fiscal policy is that of development. Development seems to indicate economic growth, and that is, in fact, its overall purpose. However, fiscal policy is far more complicated than determining how much the government will tax citizens one year and then determining how that money will be spent. True economic growth occurs when various projects are financed and carried out using borrowed funds. This stems from the the belief that the private sector cannot grow the economy by itself. Instead, some government input and influence are needed. Borrowing funds for this economic growth is one way in which the government brings about development. This economic model developed by John Maynard Keynes has been adopted in various forms since the World War II era. The function of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. Second, if the government cuts taxes or increases transfer payments, households disposable income rises, and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand. Another function is that fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing BONDS. In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise INTEREST RATES and crowd out some private INVESTMENT, thus reducing the fraction of output composed of private investment. 3. COORDINATING FISCAL POLICY AND MONETARY POLICY Monetary policy is concerned with the regulation of the availability, cost and allocation of money and credit in the economy. Fiscal policy refers to governments programs

for public spending and its resource mobilization strategy for meeting these expenditures. Monetary and fiscal policies are very closely related to each other despite the fact that these two sets of policies are sometimes different in terms of scope, transmission mechanisms and time involved in influencing the macroeconomic variables. Fiscal and monetary policies have profound impact on the level and composition of savings, investment, output and employment as well as the viability of external account. The level and structure of taxation, magnitude and the pattern of public expenditures, the dimensions of the fiscal deficit and the sour ces of financing it, changes in money supply, availability and distribution of credit as well as its cost are major determinants of the production structure and employment levels aside from their significant impact on price level and movement of exchange rate. The basic rationale for the monetary and fiscal policy coordination and the associated institutional and operational arrangements derive from the following interrelated objectives: To set internally consistent and mutually agreed targets of monetary and fiscal policies with a view to achie ve non-inflationary stable growth.

 To facilitate effective implementation of policy decisions to achieve the set targets of monetary and fiscal policies effi ciently through mutually supportive information sharing and purposeful discussions. To compel both the central bank and government to adopt a sustainable Policy Without efficient policy coordination, financial instability could ensue, leading to high interest rates, exchange rate pressures, rapid inflation, and adverse impact on economic growth. A weak policy stance in one area burdens the other area and is unsustainable in the long run. For example lax fiscal policy w ill put pressure to tighten the monetary policy, even if the latter cannot fully compensate for fiscal imbalance. More over, the lack of credibility of overall policy framework cau sed by the long run inconsistency of such policy mix will diminish the effectiveness of the monetary policy. The effective implementation of macroeconomic policies thus requires extensive coordination between the two authorities - central bank and the government. The establishment and development of domestic capital markets require an even greater degree of policy coordination. The domestic fi nancial market provides least distortionary sources of financing the fiscal deficit, while the need to pay market determined debt

service cost acts as a deterrent to large fis cal deficits. At the same time, these markets allow the central bank to conduct monetary policy more efficiently through the use of indirect market-based instruments. Finally domestic financial markets impose a discipline on both the authorities given their responsi bilities in ensuring a stable financial environment that would be conducive to main taining orderly and efficient conditions in such markets. The need for policy coordination also arises in the case of structural reforms and liberalization of the financial sector. Su ch reforms can only proceed within the framework of a supportive fiscal policy that provides macroeconomic stability, fiscal discipline, and avoidanc e of taxes that discriminate ag ainst financial activity. Together with improved legal, accounting and regulator y systems in the financial sector, these are the prerequisites for successful financial liberalization [World Bank (1989)]. If high fiscal deficits persist while the authorities are unde rtaking the reforms of the financial sector, interest rates could reach very hi gh levels or, if the interest rates are kept at artificially low levels, either inflation would surge or the demand for credit and distortions in resource allocations would grow significantly . In either case, the financial reform program more than likely will be unsuccessful.

References Textbook: Delong, Bradford, et al. Macroeconomics, 2nd Edition. Mcgraw Hill Companies, New York, USA,2006 Websites: 1. http://wiki.answers.com/Q/Function_of_fiscal_policy#ixzz21dpmvSwQ 2. http://smallbusiness.chron.com/four-major-functions-fiscal-policy32485.html 3. http://www.investopedia.com/articles/04/051904.asp/#ixzz21dmkVqtd 4. http://www.econlib.org/library/Enc/FiscalPolicy.html