Fiscal policy

Fiscal Policy

Basics of Fiscal Policy

  • Fiscal policy refers to the use of government spending and taxation to influence the economy.
  • It’s one of the most important tools that a government has to manage an economy, largely used to either stabilise economic growth during business cycle fluctuations or stimulate long-term growth.

Instruments of Fiscal Policy

  • Government spending: This involves expenditure on goods and services, transfers (like unemployment benefits), and public capital investment (like infrastructure).
  • Taxation: This can be either direct tax (like income tax and corporation tax) or indirect tax (like VAT and excise duties).

Expansionary vs Contractionary Fiscal Policy

  • Expansionary fiscal policy involves increased government spending and/or decreased taxes, generally aimed to stimulate economic growth during a recession or economic downturn.
  • Contractionary fiscal policy involves decreased government spending and/or increased taxes, primarily used to slow down an overheated economy and control inflation.

Impacts of Fiscal Policy

  • Aggregate demand: Fiscal policy affects aggregate demand - through government spending, it directly increases aggregate demand, while tax changes impact consumers’ disposable income, altering consumption levels.
  • Inflation: Expansionary fiscal policy can lead to inflation if the economy is close to or at full employment.
  • Public deficit and debt: If a government spends more than its revenue, it incurs public deficit, which accumulates over time into public debt. High public debt may crowd out private investment and hinder economic growth.
  • Income distribution: Progressive taxation and government spending on social welfare and public services can address income inequality and promote a fairer distribution of income.

Limitations of Fiscal Policy

  • Time lags: Fiscal policy takes time to implement and to have an effect on the economy, which may lead to policy intervention occurring at the wrong time.
  • Political considerations: Decisions regarding fiscal policy may be influenced by political considerations, rather than purely economic ones, which can lead to inefficient outcomes.
  • Crowding out effect: Increased government spending may lead to higher interest rates, which in turn might result in reduced private investment, a phenomenon known as the crowding out effect.

Mastering these topics about fiscal policy will equip you with a profound understanding of how government’s financial manoeuvres affect the economy domestically and globally.