FISCAL POLICY

In economics, fiscal policy is the use of government expenditure and revenue collection to influence the economy.  Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the money supply. The two main instruments of fiscal policy are government expenditure and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy.

1.     Fiscal Policy and Aggregate Demand

Traditionally   fiscal  policy   has  been   seen  as  an  instrument  of   demand management.  Fiscal policy can be used ‘’counter-cyclically’’ to help smooth out some of the volatility of output. The recent years there has been a large fiscal stimulus to the UK economy through increases in government spending on transport, health and education. The Keynesian school argues that fiscal policy can have powerful effects on aggregate demand, output and employment, particularly, when the economy is operating well below fill capacity national output.

     Aggregate Demand  (AD)  is  the  total demand for goods and services produced in the economy over a period of time.

Aggregate planned expenditure for goods and services in the economy

C + I + G + (X-M)

C = Consumers' expenditure

I  = Gross Domestic Fixed Capital Formation

G = General Government Final Consumption

X = Exports of goods and services

M = Imports of goods and services

Aggregate demand normally rises as the price level falls. This can be explained in three main ways:

Shifts in Aggregate Demand

A change in one of the components of aggregate demand will cause a shift in the aggregate demand curve. For example there might be an increase in export demand causing an injection of foreign demand into the domestic economy. The government may also increase its own expenditure and businesses may raise the level of planned capital investment spending.

     Multiplier Effects  : The expansion of a country's money supply that results from banks being able to lend. The size of the multiplier effect depends on the percentage of deposits that banks are required to hold as reserves. In other words, it is money used to create more money and is calculated by dividing total bank deposits by the reserve requirement. 

Various types of fiscal multipliers

The following values are theoretical values based on simplified models, and the empirical values corresponding to the reality have been found to be lower (see below).

Note: In the following examples the multiplier is the right-hand-side equation without the first component.

The multiplier effect refers to the phenomenon that occurs when the increase/decrease in GDP is greater than the initial change in spending.

The multiplier effect can be seen in the above graph.  The small increase in aggregate expenditures (AE1 to AE2) causes a much larger increase in equilibrium GDP (GDP1 to GDP2).

Mathematically, multiplier = change in real GDP / initial change in spending.

Example: If GDP increases by 20 million and initial increase in investment is 5 million, the multiplier is 4 (20 / 5).

 Three points to remember about the multiplier:

• All components of GDP are affected by the multiplier, but it is usually associated with investment because it is so volatile
• The initial change refers to upshift or downshift in the aggregate expenditures schedule due to a change in one of its components (movement from AE1 to AE2)

          

• The multiplier works in both directions (up or down)

     Crowding Out : is any reduction in private consumption or investment that occurs because of an increase in government spending. If the increase in government spending is not accompanied by a tax increase, government borrowing to finance the increased government spending would increase interest rates, leading to a reduction in private investment.

2.     Fiscal Policy in Different Countries

     Government Spending : Our discussion to this point has centered on U.S. fiscal policy.  But fiscal policy and the role of government in the economy can be very different across countries.  Government has plated an increasingly larger role in the major industrial countries over time.

    

     Taxation : There are two different types of taxes direct taxes (on individuals and firms) and indirect taxes (on goods and services). The most obvious different is that personal income taxes are much more important in industrial countries than in developing countries.