fiscal policy - Economic effects of fiscal policy

The use by government of tax and its own rate of spending to influence demand in the economy. When a government decides to lower taxes or raise public expenditure, the effect is to stimulate economic activity by increasing the demand for goods and services. There is a risk that this may lead to increasing inflation, or an increase in imports, resulting in a trade deficit. In contrast, a tightening of fiscal policy is where taxes are raised or public expenditure is reduced, in order to reduce aggregate demand.

Fiscal policy is the economic term that defines the set of principles and decisions of a government in setting the level of public expenditure and how that expenditure is funded. Fiscal Policy and Monetary Policy are the macroeconomic tools that governments have at their disposal to manage the economy. Fiscal Policy is the deliberate change in government spending, government borrowing or taxes to stimulate or slow down the economy.

Types of Fiscal Policy

Expansionary fiscal policy - an increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output.

Contractionary fiscal policy - a decrease in government purchases of goods and services, an increase in net taxes, or some combination of the two for the purpose of decreasing aggregate demand and thus controlling inflation.

Neutral fiscal policy - Modest fiscal policy.

This expenditure can be funded in a number of different ways:

Taxation of the population Seignorage, the benefit from printing money Borrowing money from the population, resulting in a fiscal deficit.

Funding of deficits

A fiscal deficit is often funded by issuing bonds, like Treasury bills or consols.

Economic effects of fiscal policy

Fiscal Policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth.

Keynesian economics suggests that a government running a Budget Deficit or a lower surplus compared to the previous financial year, will stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment.

During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. The removal of funds from the economy will, by Keynesian Theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.