FISCAL POLICY:-
INRODUCTION:
In economics, fiscal policy is the use of government expenditure and revenue collection
(taxation) to influence the economy. Fiscal policy can be contrasted with the other main type of
macroeconomic policy, monetary policy, which attempts to stabilize the economy by controlling
interest rates and the money supply. The two main instruments of fiscal policy are government
expenditure and taxation. Changes in the level and composition of taxation and government
spending can impact on the following variables in the economy:
Aggregate demand and the level of economic activity;
The pattern of resource allocation;
The distribution of income.
The aim of demand side fiscal policy is to influence the overall level of aggregate demand in the
economy in an attempt to stabilise the economy as a whole. When used in this fashion, fiscal
policy is sometimes known as stabilisation policy.Supply side fiscal policy aims to improve the
supply side of the economy, thereby making UK firms more competitive on world markets. The
supply side means the conditions of supply, and therefore includes both labour markets, where
the problems are generally lack of skills, and product markets where the problems are generally
lack of investment by firms.
In the UK, the fundamental supply side problem is productivity: The UK is on average 20% less
productive (output per worker) than Germany, and 40% less than the US.
There are three fundamental reasons for this supply side weakness:
1. Basic skills levels: eg 22% of adults in the UK have poor literacy, 50% more than Germany.
This reduces productivity and increases training costs.
2. Investment in new capital equipment: This is 40% higher in Germany than in the UK,
reducing unit costs and boosting output per worker
3. R&D: The US invests 50% more as a proportion of GDP than UK firms on R&D.This
means fewer new innovative products, and fewer new techniques,again damaging
productivity.
1. Stances of fiscal policy
Methods of funding
Borrowing
Consuming prior surpluses
2. Economic effects of fiscal policy
3. Demand side fiscal policy
4. Problems with Demand Side Fiscal Policy
5. Supply Side Fiscal Policy
Taxes and Government Spending
Fiscal policy describes two governmental actions by the government. The first is taxation. By
levying taxes the government receives revenue from the populace. Taxes come in many varieties
and serve different specific purposes, but the key concept is that taxation is a transfer of assets
from the people to the government. The second action is government spending. This may take
the form of wages to government employees, social security benefits, smooth roads, or fancy
weapons. When the government spends, it transfers assets from itself to the public (although in
the case of weaponry, it is not always so obvious that the population holds the assets). Since
taxation and government spending represent reversed asset flows, we can think of them as
opposite policies.
Types of Fiscal Policy
The government has control over both taxes and government spending. When the government
uses fiscal policy to increase the amount of money available to the populace, this is called
expansionary fiscal policy. Examples of this include lowering taxes and raising government
spending. When the government uses fiscal policy to decrease the amount of money available to
the populace, this is called contractionary fiscal policy. Examples of this include increasing taxes
and lowering government spending.
There is another way to interpret the terms expansionary and contractionary when discussing
fiscal policy. If we look at the effects of fiscal policy on the economy as a whole rather than on
the individual, we see that expansionary fiscal policy increases the output, or national income,
while contractionary fiscal policy decreases the output, or national income. Thus, there are two
basic classes of effects of fiscal policy, those that deal with the individual and those that deal
with the economy at large.
Interest Rates and Fiscal Policy
Fiscal policy has a clear effect upon output. But there is a secondary, less readily apparent fiscal
policy effect on the interest rate.
Basically, expansionary fiscal policy pushes interest rates up, while contractionary fiscal policy
pulls interest rates down. The rationale behind this relationship is fairly straightforward. When
output increases, the price level tends to increase as well. This relationship between the real
output and the price level is implicit. According to the theory of money demand, as the price
level rises, people demand more money to purchase goods and services. Given that there is no
change in the money supply, this increased demand for money leads to an increase in the interest
rate. The opposite is the case with contractionary fiscal policy. When output decreases, the price
level tends to fall as well. Again, this relationship between the real output and the price level is
implicit. According to the theory of money demand, as the price level falls, people demand less
money to purchase goods and services. Given that there is no change in the money supply, this
decreased demand for money leads to a decrease in the interest rate. This is how fiscal policy
affects the interest rate.
