Various government policies are being put in place to ensure the economy functions efficiently and the government meets its economic objectives for the fiscal year. Fiscal, monetary, and supply-side policies are some examples. This article focuses on fiscal policy. It is implemented to influence aggregate demand for goods and services, employment, inflation, and economic growth. This is done through the use of government spending and taxation policies, in order to achieve various economic objectives and sustainable economic growth.
The gross domestic product (GDP) equation below measures an economy's output. It shows how, through fiscal and monetary policy, we can control various factors that affect economic activity (GDP). These are consumption (C), investment (I), government spending on goods and services (G), and exports minus imports (net exports, X - M)
GDP = C + I + G +(X - M)
For example, reducing taxes during an economic recession can stimulate consumer spending and boost business investment, leading to an increase in GDP.
Types
Expansionary Fiscal Policy
Includes an increase in government spending and reduction in taxes to increase aggregate demand. When individuals pay lower taxes, they have more money to spend or invest (higher purchasing power), stimulating higher demand. This increase in demand encourages companies to hire more, reducing unemployment and creating competition for labor.
An expansionary policy causes AD to shift to the right. For instance, lowering income taxes increases disposable income, hence increasing consumption. Then, aggregate demand will change from AD1 to AD2, and inflationary pressure will rise as the average price rises from P1 to P2. However, there will be an increase in actual output from Y1 to Y2, which will mean an increase in national income, economic growth, and a decrease in unemployment.
Contractionary Fiscal Policy
Contractionary fiscal policy decreases aggregate demand by reducing spending and increasing taxes. It is used to curb inflation, as increasing taxes reduces purchasing power, hence reducing aggregate demand.
It causes consumption to fall and the AD curve to shift to the left. Lack of demand leads to firms letting more employees go, increasing unemployment. Moreover, it will lead to a budget surplus and a decrease in the money supply (a positive impact on government debt). However, it can also lead to a recession, if AD falls by too much.
Aims
To maintain a low, stable rate of inflation, a low unemployment rate, and a stable economic environment for long-term growth
To reduce fluctuations in the business cycle
To promote an equal distribution of income
To achieve a balance between export revenue and import expenditure
To create more public assets like roads, railways, and other infrastructural works
To promote education, public health, and safety
To provide unemployment benefits, salary payments, subsidies, pensions, etc.
To raise the confidence of private investors, who will, in turn, be encouraged to expand, attracting investment and driving demand.
In the long term, it may be for sustainable growth and poverty reduction.
A real-life example of fiscal policy was during the Great Depression. During this time, unemployment was at 25%, and incomes were at their lowest. President Franklin D. Roosevelt decided to implement an expansionary fiscal policy. By increasing government spending, he created new government agencies, job programs, and the Social Security program, which still exists today. He brought the economy back on track by increasing consumer purchasing power and creating more jobs.
Advantages and Disadvantages of the Fiscal Policy
It directs spending on specific purposes.
Taxation can be used to discourage negative externalities and consumption of demerit goods.
Increasing government spending can be used to increase consumption or production of merit goods (generate positive externalities)
Short Time Lag
Implementation may be politically motivated.
The tax incentives may be spent on imports so that the money won't stay in the economy
It can create budget deficits
Reference List
BYJUS (n.d.). Difference between Contractionary and Expansionary Fiscal Policy. [online] BYJUS. Available at: https://byjus.com/commerce/difference-between-contractionary-and-expansionary-fiscal-policy/#:~:text=Contractionary%20fiscal%20policy%20is%20said.
Course Hero (n.d.). Contractionary Monetary Policy - Course Hero. [online] www.coursehero.com. Available at: https://www.coursehero.com/sg/macroeconomics/contractionary-monetary-policy/.
Faster Capital (n.d.). The Pros And Cons Of Contractionary Fiscal Policy. [online] FasterCapital. Available at: https://fastercapital.com/topics/the-pros-and-cons-of-contractionary-fiscal-policy.html#:~:text=Fiscal%20policies%20can%20have%20a [Accessed 28 Mar. 2024].
Hayes, A. (2022). Fiscal Policy vs. Monetary Policy: Pros and Cons. [online] Investopedia. Available at: https://www.investopedia.com/articles/investing/050615/fiscal-vs-monetary-policy-pros-cons.asp#toc-fiscal-policy-pros-and-cons.
Hayes, A. (2023). All About Fiscal Policy: What It Is, Why It Matters, and Examples. [online] Investopedia. Available at: https://www.investopedia.com/terms/f/fiscalpolicy.asp#toc-downside-of-expansionary-policy.
Horton, M. and El-Ganainy, A. (2022). Fiscal Policy: Taking and Giving Away. [online] IMF. Available at: https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Fiscal-Policy#:~:text=Fiscal%20policy%20is%20the%20use.
Sun, A. (2019). What is included in an expansionary fiscal policy? [online] Quora. Available at: https://qr.ae/ps2hul [Accessed 28 Mar. 2024].
The Economic Times (2023). What is Fiscal Policy? Definition of Fiscal Policy, Fiscal Policy Meaning. [online] The Economic Times. Available at: https://economictimes.indiatimes.com/definition/fiscal-policy.
Comments