Fiscal policy

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In economics and political science, fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables developed in reaction to the Great Depression of the 1930s, when the previous laissez-faire approach to economic management became unworkable. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorized that government changes in the levels of taxation and government spending influences aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target inflation (which is considered "healthy" at the level in the range 2%–3%) and to increase employment. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%. [1] This implies that fiscal policy is used to stabilize the economy over the course of the business cycle. [2]

Contents

Changes in the level and composition of taxation and government spending can affect macroeconomic variables, including:

Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by a government department; while monetary policy deals with the money supply, interest rates and is often administered by a country's central bank. Both fiscal and monetary policies influence a country's economic performance.

Monetary or fiscal policy?

Since the 1970s, it became clear that monetary policy performance has some benefits over fiscal policy due to the fact that it reduces political influence, as it is set by the central bank (to have an expanding economy before the general election, politicians might cut the interest rates). Additionally, fiscal policy can potentially have more supply-side effects on the economy: to reduce inflation, the measures of increasing taxes and lowering spending would not be preferred, so the government might be reluctant to use these. Monetary policy is generally quicker to implement as interest rates can be set every month, while the decision to increase government spending might take time to figure out which area the money should be spent on. [3]

The recession of the 2000s decade shows that monetary policy also has certain limitations. A liquidity trap occurs when interest rate cuts are insufficient as a demand booster as banks do not want to lend and the consumers are reluctant to increase spending due to negative expectations for the economy. Government spending is responsible for creating the demand in the economy and can provide a kick-start to get the economy out of the recession. When a deep recession takes place, it is not sufficient to rely just on monetary policy to restore the economic equilibrium. [3] Each side of these two policies has its differences, therefore, combining aspects of both policies to deal with economic problems has become a solution that is now used by the US. These policies have limited effects; however, fiscal policy seems to have a greater effect over the long-run period, while monetary policy tends to have a short-run success. [4]

In 2000, a survey of 298 members of the American Economic Association (AEA) found that while 84 percent generally agreed with the statement "Fiscal policy has a significant stimulative impact on a less than fully employed economy", 71 percent also generally agreed with the statement "Management of the business cycle should be left to the Federal Reserve; activist fiscal policy should be avoided." [5] In 2011, a follow-up survey of 568 AEA members found that the previous consensus about the latter proposition had dissolved and was by then roughly evenly disputed. [6]

Stances

Depending on the state of the economy, fiscal policy may reach for different objectives: its focus can be to restrict economic growth by mediating inflation or, in turn, increase economic growth by decreasing taxes, encouraging spending on different projects that act as stimuli to economic growth and enabling borrowing and spending. The three stances of fiscal policy are the following:

However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral and effective fiscal policy stance.

Methods of fiscal policy funding

Governments spend money on a wide variety of things, from the military and police to services such as education and health care, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:

Borrowing

A fiscal deficit is often funded by issuing bonds such as Treasury bills or and gilt-edged securities but can also be funded by issuing equity. Bonds pay interest, either for a fixed period or indefinitely that is funded by taxpayers as a whole. Equity offers returns on investment (interest) that can only be realized in discharging a future tax liability by an individual taxpayer. If available government revenue is insufficient to support the interest payments on bonds, a nation may default on its debts, usually to foreign creditors. Public debt or borrowing refers to the government borrowing from the public. It is impossible for a government to "default" on its equity since the total returns available to all investors (taxpayers) are limited at any point by the total current year tax liability of all investors.

Dipping into prior surpluses

A fiscal surplus is often saved for future use, and may be invested in either local currency or any financial instrument that may be traded later once resources are needed and the additional debt is not needed.

Fiscal straitjacket

The concept of a fiscal straitjacket is a general economic principle that suggests strict constraints on government spending and public sector borrowing, to limit or regulate the budget deficit over a time period. Most US states have balanced budget rules that prevent them from running a deficit. The United States federal government technically has a legal cap on the total amount of money it can borrow, but it is not a meaningful constraint because the cap can be raised as easily as spending can be authorized, and the cap is almost always raised before the debt gets that high.

Economic effects

Governments use fiscal policy to influence the level of aggregate demand in the economy, so that certain economic goals can be achieved:

The Keynesian view of economics suggests that increasing government spending and decreasing the rate of taxes are the best ways to have an influence on aggregate demand, stimulate it, while decreasing spending and increasing taxes after the economic expansion has already taken place. Additionally, Keynesians argue that expansionary fiscal policy should be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the expansion that would follow; this was the reasoning behind the New Deal.

The IS curve shifts to the right, increasing real interest rates (r) and expansion in the "real" economy (real GDP, or Y). Islm.png
The IS curve shifts to the right, increasing real interest rates (r) and expansion in the "real" economy (real GDP, or Y).

The IS-LM model is another way of understanding the effects of fiscal expansion. As the government increases spending, there will be a shift in the IS curve up and to the right. In the short run, this increases the real interest rate, which then reduces private investment and increases aggregate demand, placing upward pressure on supply. To meet the short-run increase in aggregate demand, firms increase full-employment output. The increase in short-run price levels reduces the money supply, which shifts the LM curve back, and thus, returning the general equilibrium to the original full employment (FE) level. Therefore, the IS-LM model shows that there will be an overall increase in the price level and real interest rates in the long run due to fiscal expansion. [7]

Governments can use a budget surplus to do two things:

Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

But economists still debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out: whether government borrowing leads to higher interest rates that may offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This decreases aggregate demand for goods and services, either partially or entirely offsetting the direct expansionary impact of the deficit spending, thus diminishing or eliminating the achievement of the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective, especially in a liquidity trap where, they argue, crowding out is minimal. [8]

In the classical view, expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand, in turn, causes the currency to appreciate, reducing the cost of imports and making exports from that country more expensive to foreigners. Consequently, exports decrease and imports increase, reducing demand from net exports.

Some economists oppose the discretionary use of fiscal stimulus because of the inside lag (the time lag involved in implementing it), which is almost inevitably long because of the substantial legislative effort involved. Further, the outside lag between the time of implementation and the time that most of the effects of the stimulus are felt could mean that the stimulus hits an already-recovering economy and overheats the ensuing h rather than stimulating the economy when it needs it.

Some economists are concerned about potential inflationary effects driven by increased demand engendered by a fiscal stimulus. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage inflation and therefore price inflation.

See also

Related Research Articles

Keynesian economics Group of macroeconomic theories

Keynesian economics are the various macroeconomic theories and models of how aggregate demand strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. Instead, it is influenced by a host of factors – sometimes behaving erratically – affecting production, employment, and inflation.

Macroeconomics Study of an economy as a whole

Macroeconomics is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole. For example, using interest rates, taxes, and government spending to regulate an economy’s growth and stability. This includes regional, national, and global economies. According to a 2018 assessment by economists Emi Nakamura and Jón Steinsson, economic "evidence regarding the consequences of different macroeconomic policies is still highly imperfect and open to serious criticism."

Stagflation Both high inflation and high unemployment

In economics, stagflation or recession-inflation is a situation in which the inflation rate is high, the economic growth rate slows, and unemployment remains steadily high. It presents a dilemma for economic policy, since actions intended to lower inflation may exacerbate unemployment.

Inflation Rise in price level in an economy over time

In economics, inflation refers to a general progressive increase in prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money. The opposite of inflation is deflation, a sustained decrease in the general price level of goods and services. The common measure of inflation is the inflation rate, the annualised percentage change in a general price index.

In economics, the fiscal multiplier is the ratio of change in national income arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change in national income arising from any autonomous change in spending. When this multiplier exceeds one, the enhanced effect on national income may be called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased income and hence increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output that is a multiple of the initial change.

Economic policy Actions that governments take in the economic field

The economic policy of governments covers the systems for setting levels of taxation, government budgets, the money supply and interest rates as well as the labour market, national ownership, and many other areas of government interventions into the economy.

Deficit spending Spending in excess of revenue

Within the budgetary process, deficit spending is the amount by which spending exceeds revenue over a particular period of time, also called simply deficit, or budget deficit; the opposite of budget surplus. The term may be applied to the budget of a government, private company, or individual. Government deficit spending was first identified as a necessary economic tool by John Maynard Keynes in the wake of the Great Worldwide Depression of the 1930s. It is a central point of controversy in economics, as discussed below.

Government budget balance Difference between revenues and spending

A government budget is a financial statement presenting the government's proposed revenues and spending for a financial year. The government budget balance, also alternatively referred to as general government balance, public budget balance, or public fiscal balance, is the overall difference between government revenues and spending. A positive balance is called a government budget surplus, and a negative balance is a government budget deficit. A budget is prepared for each level of government and takes into account public social security obligations.

Austerity Policies to cut spending to reduce government deficit or debt

Austerity is a set of political-economic policies that claims to aim to reduce government budget deficits through spending cuts, tax increases, or a combination of both. There are three primary types of austerity measures: higher taxes to fund spending, raising taxes while cutting spending, and lower taxes and lower government spending. Austerity measures are often used by governments that find it difficult to borrow or meet their existing obligations to pay back loans. The measures are meant to reduce the budget deficit by bringing government revenues closer to expenditures. Proponents of these measures state that this reduces the amount of borrowing required and may also demonstrate a government's fiscal discipline to creditors and credit rating agencies and make borrowing easier and cheaper as a result.

Government spending Government consumptions, investments, and transfer payments

Government spending or expenditure includes all government consumption, investment, and transfer payments. In national income accounting, the acquisition by governments of goods and services for current use, to directly satisfy the individual or collective needs of the community, is classed as government final consumption expenditure. Government acquisition of goods and services intended to create future benefits, such as infrastructure investment or research spending, is classed as government investment. These two types of government spending, on final consumption and on gross capital formation, together constitute one of the major components of gross domestic product.

In economics, crowding out is a phenomenon that occurs when increased government involvement in a sector of the market economy substantially affects the remainder of the market, either on the supply or demand side of the market.

Balanced budget Financial plan where revenues equal expenses

A balanced budget is a budget in which revenues are equal to expenditures. Thus, neither a budget deficit nor a budget surplus exists. More generally, it is a budget that has no budget deficit, but could possibly have a budget surplus. A cyclically balanced budget is a budget that is not necessarily balanced year-to-year, but is balanced over the economic cycle, running a surplus in boom years and running a deficit in lean years, with these offsetting over time.

Debt monetization or monetary financing is the practice of a government borrowing money from the central bank to finance public spending instead of selling bonds to private investors or raising taxes. The central banks who buy government debt, are essentially creating new money in the process to do so.

Modern Monetary Theory Macroeconomic theory

Modern Monetary Theory or Modern Money Theory (MMT) is a heterodox macroeconomic theory that describes currency as a public monopoly and unemployment as evidence that a currency monopolist is overly restricting the supply of the financial assets needed to pay taxes and satisfy savings desires. MMT is opposed to the mainstream understanding of macroeconomic theory, and has been criticized by many mainstream economists.

2008–2009 Keynesian resurgence Great Recession-era revival of interest in aggregate demand-side economics

Following the global financial crisis of 2007–2008, there was a worldwide resurgence of interest in Keynesian economics among prominent economists and policy makers. This included discussions and implementation of economic policies in accordance with the recommendations made by John Maynard Keynes in response to the Great Depression of the 1930s, most especially fiscal stimulus and expansionary monetary policy.

In macroeconomics, particularly in the history of economic thought, the Treasury view is the assertion that fiscal policy has no effect on the total amount of economic activity and unemployment, even during times of economic recession. This view was most famously advanced in the 1930s by the staff of the British Chancellor of the Exchequer. The position can be characterized as:

Any increase in government spending necessarily crowds out an equal amount of private spending or investment, and thus has no net impact on economic activity.

Stimulus (economics) Attempts to use monetary or fiscal policy to stimulate the economy

In economics, stimulus refers to attempts to use monetary policy or fiscal policy to stimulate the economy. Stimulus can also refer to monetary policies such as lowering interest rates and quantitative easing.

Economic recovery Phase of the business cycle following a recession

An economic recovery is the phase of the business cycle following a recession. The overall business outlook for an industry looks optimistic during the economic recovery phase.

A balance sheet recession is a type of economic recession that occurs when high levels of private sector debt cause individuals or companies to collectively focus on saving by paying down debt rather than spending or investing, causing economic growth to slow or decline. The term is attributed to economist Richard Koo and is related to the debt deflation concept described by economist Irving Fisher. Recent examples include Japan's recession that began in 1990 and the U.S. recession of 2007-2009.

Crowding-in is a phenomenon that occurs when higher government spending leads to an increase in economic growth and therefore encourages firms to invest due to the presence of more profitable investment opportunities. The crowding-in effect is observed when there is an increase in private investment due to increased public investment, for example, through the construction or improvement of physical infrastructures such as roads, highways, water and sanitation, ports, airports, railways, etc. According to Post – Keynesian macroeconomics views, in a modern economy operating below capacity, government borrowings can increase demand by generating employment, thereby encouraging private investment, thus leading to crowding-in.

References

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  2. O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey: Pearson Prentice Hall. p. 387. ISBN   978-0-13-063085-8.
  3. 1 2 Pettinger, Tejvan. "Difference between monetary and fiscal policy". Economics.Help.org. Economics.Help.org. Retrieved April 26, 2019.
  4. Schmidt, Michael. "A Look at Fiscal and Monetary Policy". Invetopedia. Dotdash. Retrieved April 26, 2019.
  5. Fuller, Dan; Geide-Stevenson, Doris (Fall 2003). "Consensus Among Economists: Revisited". The Journal of Economic Education . 34 (4): 369–387. doi:10.1080/00220480309595230. JSTOR   30042564.
  6. Fuller, Dan; Geide-Stevenson, Doris (2014). "Consensus Among Economists – An Update". The Journal of Economic Education . Taylor & Francis. 45 (2): 131–146. doi:10.1080/00220485.2014.889963.
  7. Acemoglu, Daron; David I. Laibson; John A. List (2018). Macroeconomics (Second ed.). New York. ISBN   978-0-13-449205-6. OCLC   956396690.
  8. "Cliff Notes, Economic Effecs of Fiscal Policy". Archived from the original on April 10, 2013. Retrieved March 20, 2013.

Bibliography