Fiscal Policy

Understanding Fiscal Policy

  • Fiscal policy refers to the use of government spending and taxation to influence the economy.
  • It is one of the main tools that governments use to manage and manipulate economic conditions.
  • Fiscal policy stands as a counterbalance to monetary policy, which involves changing interest rates and controlling the money supply.

The Two Types of Fiscal Policy

  • Expansionary fiscal policy involves increasing government spending or cutting taxes. This can stimulate economic activity during a recession and boost economic growth.
  • Contractionary fiscal policy is about decreasing government spending or raising taxes. This can slow down economic activity during a period of overheating or inflation, bringing about stability.

Effects of Fiscal Policy

  • Public services and infrastructure: If the government increases spending on these areas, this can lead to job creation and increased productivity.
  • Disposable income: Adjusting tax levels can change people’s disposable income, which in turn affects consumer spending and aggregate demand.
  • Government deficit and debt: Fiscal policy decisions can affect public debt levels. Expansionary policies may increase borrowing, whereas contractionary policies may reduce it.

Fiscal Policy and Economic Objectives

  • Full employment: Expansionary fiscal policy can stimulate job growth by increasing demand for goods and services.
  • Economic growth: Government spending in strategic areas can boost long-term productivity and stimulate economic growth.
  • Inflation: If the economy is overheating, contractionary fiscal policy can be used to cool down demand and control inflation.
  • Reducing disparities in wealth and income: Fiscal policy, particularly through taxation, can assist in redressing inequalities.

Setbacks of Fiscal Policy

  • Time lags: The effects of fiscal policy can take a considerable time to materialise.
  • Political influences: Fiscal policy decisions can be influenced by political agendas and electoral cycles, which may not always align with wider economic objectives.
  • Crowding out: Increased government borrowing to finance spending can lead to higher interest rates, which may deter private investment.