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Definition Government spending policies that influence macroeconomic conditions. These policies affect tax rates, interest rates and government spending, in an effort to control the economy. What is Fiscal Policy? Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nations economy. Fiscal policy and Monetary policy go hand in hand with each other. Both are interdependent on each other. Before the Great Depression in the United States, the governments approach to the economy was laissez faire. But following the Second World War, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mixture of both monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments are able to control economic phenomena. Objectives of Fiscal Policy 1. To achieve desirable price level: The stability of general prices is necessary for economic stability. The maintenance of a desirable price level has good effects on production, employment and national income. Fiscal policy should be used to remove; fluctuations in price level so that ideal level is maintained. 2. To Achieve desirable consumption level: A desirable consumption level is important for political, social and economic consideration. Consumption can be affected by expenditure and tax policies of the government. Fiscal policy should be used to increase welfare of the economy through consumption level. 3. To Achieve desirable employment level: The efficient employment level is most important in determining the living standard of the people. It is necessary for political stability and for maximization of production. Fiscal policy should achieve this level. 4. To achieve desirable income distribution:
The distribution of income determines the type of economic activities the amount of savings. In this way, it is related to prices, consumption and employment. Income distribution should be equal to the most possible degree. Fiscal policy can achieve equality in distribution of income. 5. Increase in capital formation: In under-developed countries deficiency of capital is the main reason for underdevelopment. Large amounts are required for industry and economic development. Fiscal policy can divert resources and increase capital. 6. Degree of inflation: In under-developed countries, a degree of inflation is required for economic development. After a limit, inflationary be used to get rid of this situation.
with Keynes and his followers. The classical view of expansionary or contractionary fiscal policies is that such policies are unnecessary because there are market mechanismsfor example, the flexible adjustment of prices and wageswhich serve to keep the economy at or near the natural level of real GDP at all times. Accordingly, classical economists believe that the government should run a balanced budget each and every year. Combating a recession using expansionary fiscal policy. Keynesian theories of output and employment were developed in the midst of the Great Depression of the 1930s, when unemployment rates in the U.S. and Europe exceeded 25% and the growth rate of real GDP declined steadily for most of the decade. Keynes and his followers believed that the way to combat the prevailing recessionary climate was not to wait for prices and wages to adjust but to engage in expansionary fiscal policy instead. The Keynesians' argument in favor of expansionary fiscal policy is illustrated in Figure 1 .
Figure 1Combating a recession using expansionary fiscal policy Assume that the economy is initially in a recession. The equilibrium level of real GDP, Y1, lies below the natural level, Y2, implying that there is less than full employment of the economy's resources. Classical economists believe that the presence of unemployed resources causes wages to fall, reducing costs to suppliers and causing the SAS curve to shift from SAS1 to SAS2, thereby restoring the economy to full employment. Keynesians, however, argue that wages are sticky downward and will not adjust quickly enough to reflect the reality of unemployed resources. Consequently, the recessionary climate may persist for a long time. The way out of this difficulty, according to the Keynesians, is to run a budget deficit by increasing government expenditures in excess of current tax receipts. The increase in government expenditures should be sufficient to cause the aggregate demand curve to shift to the right from AD1 to AD2, restoring the economy to the natural level of real GDP. This increase in government expenditures need not, of course, be equal to the difference between Y1 and Y2. Recall that any increase in autonomous aggregate expenditures, including government expenditures, has a multiplier effect on aggregate demand. Hence, the government needs only to increase its expenditures by a small amount to cause aggregate demand to increase by the amount necessary to achieve the natural level of real GDP.
Keynesians argue that expansionary fiscal policy provides a quick way out of a recession and is to be preferred to waiting for wages and prices to adjust, which can take a long time. As Keynes once said, In the long run, we are all dead. Combating inflation using contractionary fiscal policy. Keynesians also argue that fiscal policy can be used to combat expected increases in the rate of inflation. Suppose that the economy is already at the natural level of real GDP and that aggregate demand is projected to increase further, which will cause the AD curve in Figure 2 to shift from AD1 to AD2.
Figure 2Combating inflation using contractionary fiscal policy As real GDP rises above its natural level, prices also rise, prompting an increase in wages and other resource prices and causing the SAS curve to shift from SAS1 to SAS2. The end result is inflation of the price level from P1 to P3, with no change in real GDP. The government can head off this inflation by engaging in a contractionary fiscal policy designed to reduce aggregate demand by enough to prevent the AD curve from shifting out to AD2. Again, the government needs only to decrease expenditures or increase taxes by a small amount because of the multiplier effects that such actions will have.