Fiscal Policy

Fiscal policy is carried out by the legislative and/or the executive branches of government. The two main instruments of fiscal policy are: 1 Government expenditures 2 Taxes. The government collects taxes in order to finance expenditures on a number of public goods and servicesfor example, highways and national defense. Expansionary Fiscal Policy. Expansionary fiscal policy is defined as an increase in government expenditures and/or a decrease in taxes that causes the government's budget deficit to increase or its budget surplus to decrease. Contractionary Fiscal Policy Contractionary fiscal policy is defined as a decrease in government expenditures and/or an increase in taxes that causes the government's budget deficit to decrease or its budget surplus to increase. Classical and Keynesian views of fiscal policy. The belief that expansionary and contractionary fiscal policies can be used to influence macroeconomic performance is most closely associated 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 wages which 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 1 Combating 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 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 2 Combating 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. Secondary effects of fiscal policy Classical economists point out that the Keynesian view of the effectiveness of fiscal policy tends to ignore the secondary effects that fiscal policy can have on credit market conditions. When the government pursues an expansionary fiscal policy, it finances its deficit spending by borrowing funds from the nation's credit market. Assuming that the money supply remains constant, the government's borrowing of funds in the credit market tends to reduce the amount of funds available and thereby drives up interest rates. Higher interest rates, in turn, tend to reduce or crowd out aggregate investment expenditures and consumer expenditures that are sensitive to interest rates. Hence, the effectiveness of expansionary fiscal policy in stimulating aggregate demand will be mitigated to some degree by this crowding-out effect. The same holds true for contractionary fiscal policies designed to combat expected inflation. If the government reduces its expenditures and thereby reduces its borrowing, the supply of available funds in the credit market increases, causing the interest rate to fall. Aggregate demand increases as the private sector increases its investment and interest-sensitive consumption expenditures. Hence, contractionary fiscal policy leads to a crowding-in effect on the part of the private sector. This crowding-in effect mitigates the effectiveness of the contractionary fiscal policy in counteracting rising aggregate demand and inflationary pressures

The purpose of fiscal policy.

A fiscal policy is when the government changes taxation and increases government spending. Through an expansionary fiscal policy it aims at increasing the amount of disposable income people will have. This income will, depending on the marginal propensity to consume, be spent in the economy. The result of this will be that aggregate demand will increase thus eliminating the deflationary gap which is caused by either growth or unemployment. Moreover fiscal policy aims at increasing government spending. If government spending increases the investment in the economy which will be translated as an increase of investment in the economy and which will in turn close the deflationary gap. Through a contractionary demand side policy the government aims at decreasing the amount of disposable income and thus reducing consumption within the economy which will in turn lead in a reduction of aggregate demand. In terms of government spending the government will reduce government spending so as to reduce investment and t hus close the inflationary gap as illustrated by the following diagram.

As seen in the above diagram when an economy is faced with a deflationary gap its aim is to push the real consumption function leftward so as to close this gap which usually reflects either lack of growth or unemployment. In other words what this fiscal policy aims at is increasing consumption and thus in turn reducing unemployment and/or recession. On the other hand when the economy is faced with an inflationary gap it aims at shifting the real consumption function rightward so as to close that gap and thus eliminate inflation. If however we examine the policies best fitted to increasing growth and combating unemployment, we will see that a fiscal policy is not always the best approach. In the case of equilibrium unemployment we see that there are several types of unemployment and thus several economic policies to combat them. In the case of frictional unemployment we see that the best policy to combat it is by reducing job dissatisfaction through increasing job information and by

reducing unemployment benefits so people have a disincentive to remain unemployed. In the case of structural unemployment we could increase education so as to eliminate occupational immobility and improve transportation so as to eliminate geographic immobility. Finally in the case of seasonal unemployment the government could spread economic activities for a longer time period. Thus from the above we conclude that in the case of equilibrium unemployment there is no point in using a fiscal policy seeing that this type of employment doesnt occur due to lack of demand. In the case of disequilibrium unemployment the government could either reduce government intervention in the labor market or reduce the power of labor unions so as to make the labor market more flexible to wage changes. Thus we see again that a fiscal policy has no exact purpose here because an increase in demand cant permanently secure that the economy will never fall in recession so that wages wont have to fall. In the case of the economy wishing to stimulate growth a fiscal policy could prove very effective seeing that it increases the two main elements of demand namely domestic consumption and investment thus will probably trigger development. However the government has to be very cautious in assuring that this rapid development wont lead the country to inflation or nonsustainable development. Also if the economy is trying to combat inflation and it tries to implement a demand side policy this may lead to a dramatic increase in unemployment which is what happened in the case of Spain when it was trying to enter the EU. Thus we see that while a fiscal policy does affect aggregate demand and does close the deflationary or inflationary gap the government due to several problems may not be able to stop implementing the policy exactly at the point when the gap has closed. This may cause inflation or unemployment to surge which is one of the main problems of demand-side policies, thus one may ask why the government prefers fiscal demand-side policies to supply-side policies. The fact is that despite their problems demand-side policies work faster than supply-side policies because the improvement in the factors of production supply-side policies aim at takes time to be fulfilled. Thus since the government needs to work fast so as to avoid an economic crisis a fiscal policy may prove to be more effective than a supply-side policy. Thus from the above we conclude that the purpose of a fiscal policy is to eliminate a deflationary or inflationary gap in the economy as fast as possible so as to prevent an economic crisis and through this to fine tune and control the economy.

Effectiveness of fiscal policy.

Although a fiscal policy does achieve in helping the economy for a short period of time by affecting the elements of aggregate demand namely investment and consumption it does have several problems that hinder its effectiveness. On the one hand as previously stated an expansionary fiscal policy by decreasing taxation and increasing government spending the fiscal policy will probably achieve in increasing aggregate demand. This will happen since the decrease in taxation will increase peoples disposable income and consequently depending on the marginal propensity to consume the domestic consumption of an economy which in turn will increase aggregate demand. Similarly the government by increasing spending in all sectors of its economy it will increase investment which in turn may lead to an increase in aggregate demand. This is an effective way to combat economic problems such as unemployment and recession. On the other hand if a government wants to eliminate recession it will have to pursue a contractionary demand side policy. This policy will increase taxation thus decreasing the citizens disposable income thus in turn reducing consumption which will reduce aggregate demand which will in turn reduce inflation. On the other hand it will decrease government spending thus decreasing investment which will again reduce aggregate demand and thus in turn reduce inflation. However these policies arent always very effective for several reasons. Firstly fiscal policy cant be effective if consumption isnt effective to tax changes in other words if there is a high marginal propensity to consume. What this will mean is that no matter how high the government raises taxes the people will still insist on spending as much as they previously did thus not decreasing domestic consumption. On the other hand if there is low marginal propensity to consume no matter how low the government drops the tax domestic consumption wont increase and thus domestic consumption wont increase. Moreover a fiscal policy could lead to the crowding out effect. This is divided in two categories, resources and financial crowding out. In the case of resources crowding out this indicates an increase in reward for the factors of production. This happens in the case of an expansionary fiscal policy government spending on public and merit goods as a result the government increases demand for specific factors of production. This increased demand will lead to increases in wages, rent and interest rates. In the case of financial crowding out increased government spending will lead in an increase in demand to borrow money so as to finance this spending. As a result there will be an increase in interest rates which in turn may discourage investment from private firms. Another problem that may occur is that the government may over or under estimate the problem and thus impose a non effective fiscal policy since it will either increase demand too much or too little. This may occur due to information problems seeing that information is sometimes difficult to collect on the exact position of the economy at any moment and thus may make false estimations on the extent to which the policy should be dragged. There is also the issue of time seeing that in order for the fiscal policy to be constructed this may take some time and by then the situation will be altered thus the policy wont be as effective.

Finally there is the issue of the fiscal drag that may make fiscal policies ineffective. This happens because if the government keeps increasing government spending with taxation levels remaining stable the government may move into recession and a deflationary gap might emerge. This can be explained by the fact that people earning higher income due to an increase in government spending will move to a higher income bracket and pay higher taxation something that will reduce consumption on their part and leas the economy to slowdown instead of growth. Thus from the above we see that fiscal policies are effective but in a very limited number of situations seeing that they often backfire.