Effects of fiscal policy 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 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. This is generally done during recession to boost spending and demand. What we see across the globe these days is governments after governments are coming up with their own bailout plan for recession. They have announced trillions of dollars of economic package to boost growth and generate employment. Fiscal policy in the short-run The idea of fiscal policy in the short-run is very simple- if aggregate demand is too low, the government would: Buy more goods and service Increase transfer payments Reduce tax rates on income Reduce imports and excise duties If you have read newspapers recently, you might have come across these measures. The government of India recently lowered excise duties on lot of products - naphtha imported for power generation can be imported duty free. Export duty on iron ore fines has been withdrawn; it is 5% (from 10%) on iron ore lumps. Once AD increases, firms would see an increased demand for their products and react by raising output and/or raising prices. Buying more goods and services would: Increase transfer payments would: Reducing tax rates on household income would: Increase disposable income due to lower taxes would increase spending power of individuals and hence increase in AD Reducing taxes or changing regulations that influence corporate income would: Increase business spending depending on the overall sentiments in economy

Directly increase spending and AD

Increase disposable income and generally increased spending by households

Fiscal policy in the long-run In the long-run a poor and mismanaged fiscal policy might lead to persistent deficits and accumulating government debt. Lets start with debt. To find out the health of an economy, the size of national debt is measured w.r.t. its GDP. If the national debt is equal to more than 60% of its GDP, the country is considered as a reasonable financial risk. Higher debt might bring up the issue of insolvency, which is inability of the country to meet its obligations. An insolvent government needs to reduce spending and raise tax revenues but the internal politics and economics are such that it cannot.

Now coming back to government spending, if a government is not saving, it is basically spending whatever it is earning. The nations savings is a very important source of investment because it is the nations savings that ends up in banks and other financial institutions. This savings come from three main sources- households, retained earnings of business and government. When government is not saving, it will need money to reduce its deficits. The government will then issue bonds to the public to raise money. So governments with deficits are competing with private firms for the nations savings. This not only leaves less for the firms but also drives up interest rates. Either way, the end result is that government deficits crowd out private investment spending. Crowding out 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 lower 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. Another problem is the time lag between the implementation of the policy and detectable effects in the economy. An expansionary fiscal policy (decreased taxes or increased government spending) is usually intended to produce an increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead to inflation. Hence, checks need to be kept in place.