What do you mean by fiscal policy

These austerity measures were a factor in causing lower economic growth in and Evaluation of US expansionary fiscal policy in Definition of fiscal policy Fiscal policy involves the government changing the levels of taxation and government spending in order to influence aggregate demand AD and the level of economic activity. Expansionary or loose fiscal policy This involves increasing AD. Therefore the government will increase spending G and cut taxes T.

Lower taxes will increase consumers spending because they have more disposable income C This will tend to worsen the government budget deficit, and the government will need to increase borrowing.

Diagram showing effect of expansionary fiscal policy Deflationary or tight fiscal policy This involves decreasing AD. Higher taxes will reduce consumer spending C Tight fiscal policy will tend to cause an improvement in the government budget deficit. Diagram showing the effect of tight fiscal policy UK fiscal policy UK Budget deficit In , the government pursued expansionary fiscal policy. Government borrowing also rose because of the recession leading to lower tax revenue When the new coalition government came into power in May , they argued the deficit was too high and then announced plans to reduce government borrowing.

Fine tuning — fiscal policy Definition of Fine Tuning : This involves maintaining a steady rate of economic growth by using fiscal policy. For example, if growth is below the trend rate of growth, the government can cut tax to boost spending and economic growth. If growth is too fast and inflationary, the government can increase income tax to slow down consumer spending and reduce economic growth.

In theory, the government can make incremental changes to spending and taxation levels to slow down or speed up the economy. Difficulties of fine tuning In the real world, fine tuning is difficult to achieve due to several factors.

Time lags. It takes several months for government spending to feed its way into the economy. By the time government spending increases it may be too late. Political costs. Raising taxes to reduce inflation will impose political costs as people will not like the idea of higher taxes.

Before an election it would be hard for government to raise taxes — merely to fine tune economic growth rate. Difficulty of forecasting. Fine tuning requires good information about current state of economy and likely forecasts of growth. Governments may struggle to know the extent of the output gap. The increased T and lower G will act as a check on AD. But, in a recession, the opposite will occur with tax revenue falling but increased government spending on benefits, this will help increase AD Discretionary fiscal stabilisers — This is a deliberate attempt by the government to affect AD and stabilise the economy, e.

Primary budget deficit — a measure of government spending — tax receipts but ignoring interest payments on the debt. The multiplier effect. When an increase in injections causes a bigger final increase in Real GDP. Injections J — This is an increase of expenditure in the circular flow, it includes govt spending G , Exports X and Investment I Withdrawals W — This is leakages from the circular flow This is household income that is not spent on the circular flow.

To increase government spending will take time. It could take several months for a government decision to filter through into the economy and actually affect AD. By then it may be too late. Crowding out. Some economists argue that expansionary fiscal policy higher government spending will not increase AD because the higher government spending will crowd out the private sector. This is because the government have to borrow from the private sector who will then have lower funds for private investment.

Government spending is inefficient. Free market economists argue that higher government spending will tend to be wasted on inefficient spending projects. Also, it can then be difficult to reduce spending in the future because interest groups put political pressure on maintaining stimulus spending as permanent. Higher borrowing costs. Under certain conditions, expansionary fiscal policy can lead to higher bond yields, increasing the cost of debt repayments.

Criticisms of Fiscal Policy — More detail on criticisms of fiscal policy Evaluation of fiscal policy The success of fiscal policy will depend on several factors, such as It depends on the size of the multiplier. If the multiplier effect is large, then changes in government spending will have a bigger effect on overall demand.

It depends on the state of the economy. Fiscal policy is most effective in a deep recession where monetary policy is insufficient to boost demand. In a deep recession liquidity trap. Higher government spending will not cause crowding out because the private sector saving has increased substantially. See: Liquidity trap and fiscal policy — why fiscal policy is more important during a liquidity trap. It depends on other factors in the economy. For example, if the government pursue expansionary fiscal policy, but interest rates rise, and the global economy is in a recession, it may be insufficient to boost demand.

Bond yields. If there is concern over the state of government finances, the government may not be able to borrow to finance fiscal policy. Countries in the Eurozone experienced this problem in the recession. Brief history of fiscal policy Keynes advocated the use of fiscal policy as a way to stimulate economies during the great depression.

Fiscal Policy was particularly used in the 50s and 60s to stabilise economic cycles. Fiscal policy became more prominent during the great depression of US fiscal policy Evaluation of US expansionary fiscal policy in Further Reading on Fiscal Policy Deflationary Fiscal Policy — impact on the economy of raising taxes and cutting spending. The difference between monetary and fiscal policy — Monetary policy has a similar aim to fiscal policy but involves changing interest rates and other monetary policies.

Does fiscal policy solve unemployment? Essays on fiscal policy Discuss the difficulties of recovering from recessions Is austerity self-defeating? Last updated: 10th July , Tejvan Pettinger, www. We use cookies on our website to collect relevant data to enhance your visit. Our partners, such as Google use cookies for ad personalization and measurement. However, you may visit "Cookie Settings" to provide a controlled consent.

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This cookie is used to check the status whether the user has accepted the cookie consent box. It also helps in not showing the cookie consent box upon re-entry to the website. It remembers which server had delivered the last page on to the browser. It also helps in load balancing. Hence, inflation exceeds the reasonable level.

For this reason, fine-tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals. If not closely monitored, the line between a productive economy and one that is infected by inflation can be easily blurred. When inflation is too strong, the economy may need a slowdown.

In such a situation, a government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation. Of course, the possible negative effects of such a policy, in the long run, could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of evening out the business cycles.

Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group.

In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class. Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers.

A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts, which would not do much to increase aggregate employment levels. That said, the markets also react to fiscal policy. The law also retains the current structure of seven individual income tax brackets, but in most cases it lowers the rates: the top rate falls from These changes are set to expire after One of the biggest obstacles facing policymakers is deciding how much involvement the government should have in the economy.

Indeed, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to sustain a vibrant economy, on which the economic well-being of the population depends. Congressional Budget Office. Federal Reserve. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.

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I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Changes in tax rates, the structure of taxation, and its incidence, influence the volume and direction of private spending in the economy.

As a matter of fact, all government spending is an inducement to increase the aggregate demand both volume and component and has an inflationary bias in the sense that it releases funds for the private economy which are then available for use in the course of trade and business.

Similarly, a reduction in government spending has a deflationary bias and it reduces the aggregate demand its volume and relative components in which the expenditure is curtailed. Thus, the composition of public expenditure and composition of public revenue not only help to mould the economic structure of the country, but may also be expected to exert certain effects on the economy at certain times and a quite different impact at other times.

It was Keynes who popularised the interest in fiscal policy as a measure attaining macro-economic goals like increasing the level of employment and income in an economy. Prior to Keynes, the classical economists believed in the principle of sound finance in which small and balanced budget was considered to be the ideal one. Keynes, for the first time, stressed the need of State intervention in the economic field and advocated for an unbalanced budget.

Following Keynes, A.