Fiscal Policy

Fiscal Policy

Fiscal policy is a common term that has been used in economics as well as in political science. Fiscal policy is the use of government revenues collection such as taxes and government spending to influence the economic conditions in the country. The government revenues and the expenditure are used to influence the macroeconomic variables under this policy. The economic growth, aggregate demand for the products and services, the employment rate of the country, and inflation are a few key areas that is been influenced by the government fiscal policy.

The macroeconomic influence has been developed as an outcome of the great depression which occurred in the 1930s due to the unpopularity of the laissez-faire (leave alone) approach.  Under the laissez-faire approach, the government intervention in the economy was minimal and it was believed that the businesses will be better by minimizing the government approach to the business. Since this approach was less effective, the fiscal policy came to play, creating a certain level of government intervention to make sure the economic stability of the country.

Fiscal policy was evolved based on the theories by a British economist named John Maynard Keynes. According to him, the government changes in the point of government income and expenditure. The fiscal policy has been refined to smooth since then to face the cyclical movements in the current economy. The key activities of the central bank and the other key economic objectives are implemented and accomplished by combining the country’s monetary policy and the fiscal policy.

The combination of the fiscal policy and the monetary policy creates a favorable environment to the government to control the inflation, increase the rate of employment as well as to maintain the demand for goods and services in a healthy level.

Fiscal policy types

In an economic recession period, the government may use an expansionary fiscal policy by reducing taxes and increasing government spending. It allows more money to be available in the economy for businesses or consumers. These will increase the level of consumption of the individuals, increase new business implementations, and the investment levels will stimulate. 

Even though it seems that an expansionary fiscal policy creates a favorable environment for economic growth, it is also argued that the increased government spending easily crowds out investments by the private sector. Apart from that, it is also argued that the expansionary fiscal policy can get out of hand. These can create increases in wages and lead to inflation. Forming asset bubbles can occur as a result of this. This risk will in turn lead the governments to reverse the expansion and contract the economy by increasing taxes.

Conversely, to face inflation, a government usually implements contractionary fiscal policy by reducing the spending or by raising the taxes. It reduces the availability of money for businesses or consumers. The personal consumption level will decrease and the investments and new business options will be discouraged if there is no compensatory action by the government.

By creating an effect on economic activities, the fiscal policy is used to stabilize the economy throughout the business cycle. Changing the level of government income(taxation) and government spending affects the macroeconomic variables such as

  • income distribution
  • resource allocation of the economy
  • level of savings and investment
  • aggregate demand for the goods and services

Fiscal policy can be differentiated from the monetary policy as it involves the taxation and the expenditure of the government. It is often administered by a government department and make necessary changes to maintain a stable economic performance. Finally, it is identified that both fiscal and monetary policies play a major role in stabilizing and maintaining the economy.

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