Fiscal Policy

Fiscal Policy

A macroeconomic policy which involves government spending and tax rate alteration.

Purpose of Fiscal Policy

Closing a recessionary gap - During periods of recession, when a nation's GDP falls and unemployment is high, government spending on welfare, unemployment benefits and healthcare subsidies automatically increases from the government (automatic stabilizers). To close a recessionary gap, government can deploy expansionary fiscal policy where the government can cut the tax rates and increase spending and this can offset fall in other spending and move AD back to employment level. Closing an inflationary gap - During periods of inflation, when a nation exceeds full employment and when the average price level in the country is high, government can use contractionary fiscal policy to bring down the AD level back to the equilibrium level making the average price level lower and more suitable for the citizens. This can be done by raising tax rates and decreasing spending.

Evaluation of Fiscal Policy

Crowding-out effect - increase in government spending can lead to a rise in interest rates and thus make the other components of the AD decrease (consumption & investment). Private consumption and investment is crowded out from the public sector. Time lags - It takes a lot of time to implement the policy. A couple of months. The Next Export Effect - During recession, rising unemployment, government borrows money to spend on unemployment benefits. Therefore, interest rates rise and exchange rate increases. Therefore, the price of exports becomes more expensive and exports decrease. Political Influence - Politicians might fear losing votes. They are not likely to increase the tax rate because they don't want to lose the vote.

Automatic stabilizer during economic growth

If the economy is beyond its full employment level of output, in which unemployment is very low and household and firm's incomes and revenues are high, the economy will experience automatic decrease in the government's expenditure on certain items. - government do not need to spend much on unemployment benefit, housing subsidies, welfare payments, subsidized food assistance.

Automatic stabilizer during recession

In the opposite situation, the government expenditure increases. as the economy falls. Therefore, fall in AD would be counteracted by the larger government expenditures such as unemployment benefit, housing subsidies, welfare payments, subsidized food assistance.

Deficit

When a government's total expenditure exceeds its total tax revenue in a particular year, the government is running a budget deficit. (Debt is accumulation of deficit)

Surplus

When a tax revenue exceeds government's total expenditure, the government's budget is in surplus.