Fiscal Policy

Fiscal Policy

Marks & Spencer

Introduction

FISCAL POLICY REFERS to the use of government measures to influence economic activity. It is the management of the economy through the employment of tax, spending, and transfer policy. Usually it is separate from monetary policy, which is the use of money supply in influencing economic activity. (Arestis and Sawyer, 2004) Fiscal policy first gained importance after the publication of John Maynard Keynes's General Theory of Employment, Interest and Money in 1936. Before the advent of Keynesian economics, governments and economists did not consider management of the economy through fiscal policy. When the 1932 presidential campaign was under way in the midst of a worsening depression, both candidates spoke of balancing the budget. It took Keynes's analysis to awaken economists and later policymakers to use fiscal policy to manage the economy.

Fiscal policy, since it first gained currency with Keynes, has been a matter of significant controversy. Any quantity of fiscal policy means greater government involvement in the economy and in the lives of individuals. Many free-market advocates oppose fiscal policy because of this. Demand management has been opposed by monetarists and supply-siders styled in the form of so-called Reaganomics.

The disagreement is not really whether government budget management is necessary with built-in automatic stabilizers but whether the government ought to use discretionary means to manipulate the economy. There is an important questions at stake: whether the government ought to be involved in the management of the economy?

THE BUDGET

The fiscal policy of the government is encapsulated in the budget, and if one wishes to view a snapshot of it, it can be seen as the government budget deficit—which is a summary position of the expenditures and revenue of the government. Whether the government activity seeks to use the budget as a tool in influencing the economy, any budgetary changes will mean an effect on the economic status of the economy.

The government can engage in expansionary or contractionary fiscal policy. If there are unemployed resources in the economy, the government can spend more while leaving taxes unchanged—or even reducing them—or it can reduce taxes and leave spending unchanged. This is an expansionary measure. If the government perceives growing inflation or an economy growing too rapidly, then it can take contractionary measures, that is, lower spending, raising taxes, or both.

Aggregate demand is the target of fiscal policy, whether it be of a stimulating or dampening effect. By spending more and/or taxing less, the government ultimately increases aggregate demand. But if it chooses to stimulate aggregate demand by spending more, the effects are direct. If it chooses to lower taxes, it works indirectly through household spending. A tax cut is then at the discretion of household spending and saving choices.

Consider an expansionary fiscal policy through an increase in spending. Whenever the government increases aggregate demand, there are two possible effects, and the extent of each depends on how close the economy is to full employment. The first is to increase output or income, the desired ...