Fiscal policy

Fiscal policy

Overview
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 and political science
Political science
Political Science is a social science discipline concerned with the study of the state, government and politics. Aristotle defined it as the study of the state. It deals extensively with the theory and practice of politics, and the analysis of political systems and political behavior...

, 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
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

, which attempts to stabilize the economy by controlling interest rates and spending. 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 the following variables in the economy:
  • Aggregate demand
    Aggregate demand
    In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

     and the level of economic activity;
  • The pattern of resource allocation;
  • The distribution of income.


Fiscal policy refers to the use of the government budget to influence the first of these: economic activity.

The three possible stances of fiscal policy are neutral, expansionary and contractionary.
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Encyclopedia
In economics
Economics
Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 and political science
Political science
Political Science is a social science discipline concerned with the study of the state, government and politics. Aristotle defined it as the study of the state. It deals extensively with the theory and practice of politics, and the analysis of political systems and political behavior...

, 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
Macroeconomics
Macroeconomics is a branch of economics dealing with the performance, structure, behavior, and decision-making of the whole economy. This includes a national, regional, or global economy...

, monetary policy
Monetary policy
Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting a rate of interest for the purpose of promoting economic growth and stability. The official goals usually include relatively stable prices and low unemployment...

, which attempts to stabilize the economy by controlling interest rates and spending. 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 the following variables in the economy:
  • Aggregate demand
    Aggregate demand
    In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

     and the level of economic activity;
  • The pattern of resource allocation;
  • The distribution of income.


Fiscal policy refers to the use of the government budget to influence the first of these: economic activity.

Stances of fiscal policy


The three possible stances of fiscal policy are neutral, expansionary and contractionary. The simplest definitions of these stances are as follows:
  • A neutral stance of fiscal policy implies a balanced economy. This results in a large tax revenue. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.

  • An expansionary stance of fiscal policy involves government spending exceeding tax revenue.

  • A contractionary fiscal policy occurs when government spending is lower than tax revenue.


However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclical fluctuations of the economy cause cyclical 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 fiscal policy stance.

Methods of funding


Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payment
Transfer payment
In economics, a transfer payment is a redistribution of income in the market system. These payments are considered to be exhaustive because they do not directly absorb resources or create output...

s such as welfare benefits. This expenditure can be funded
Revenue
In business, revenue is income that a company receives from its normal business activities, usually from the sale of goods and services to customers. In many countries, such as the United Kingdom, revenue is referred to as turnover....

 in a number of different ways:
  • Taxation
  • Seigniorage
    Seigniorage
    Seigniorage can have the following two meanings:* Seigniorage derived from specie—metal coins, is a tax, added to the total price of a coin , that a customer of the mint had to pay to the mint, and that was sent to the sovereign of the political area.* Seigniorage derived from notes is more...

    , the benefit from printing money
    Money
    Money is any object or record that is generally accepted as payment for goods and services and repayment of debts in a given country or socio-economic context. The main functions of money are distinguished as: a medium of exchange; a unit of account; a store of value; and, occasionally in the past,...

  • Borrowing money from the population or from abroad
  • Consumption of fiscal reserves.
  • Sale of fixed assets (e.g., land).

Borrowing


A fiscal deficit is often funded by issuing bonds
Government bond
A government bond is a bond issued by a national government denominated in the country's own currency. Bonds are debt investments whereby an investor loans a certain amount of money, for a certain amount of time, with a certain interest rate, to a company or country...

, like treasury bills or consols
Consols
Consol is a form of British government bond , dating originally from the 18th century. The first consols were originally issued in 1751...

 and gilt-edged securities. These pay interest, either for a fixed period or indefinitely. If the interest and capital requirements are too large, a nation may default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...

 on its debts, usually to foreign creditors. Public debt or borrowing : it refers to the government borrowing from the public.

Consuming 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; notice, additional debt is not needed. For this to happen, the marginal propensity to save needs to be strictly positive.

Economic effects of fiscal policy


Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics
Keynesian economics
Keynesian economics is a school of macroeconomic thought based on the ideas of 20th-century English economist John Maynard Keynes.Keynesian economics argues that private sector decisions sometimes lead to inefficient macroeconomic outcomes and, therefore, advocates active policy responses by the...

 suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand
Aggregate demand
In macroeconomics, aggregate demand is the total demand for final goods and services in the economy at a given time and price level. It is the amount of goods and services in the economy that will be purchased at all possible price levels. This is the demand for the gross domestic product of a...

. This can 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 boom that would follow; this was the reasoning behind the New Deal
New Deal
The New Deal was a series of economic programs implemented in the United States between 1933 and 1936. They were passed by the U.S. Congress during the first term of President Franklin D. Roosevelt. The programs were Roosevelt's responses to the Great Depression, and focused on what historians call...

.

Governments can use a budget surplus to do two things: to slow the pace of strong economic growth, and to stabilize prices when inflation is too high. Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

Economists debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out
Crowding out (economics)
In economics, crowding out occurs when Expansionary Fiscal Policy causes interest rates to rise, thereby reducing private spending. That means increase in government spending crowds out investment spending....

, a phenomenon where government borrowing leads to higher interest rates that 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 causes a lower aggregate demand for goods and services, contrary to 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
Liquidity trap
A liquidity trap is a situation described in Keynesian economics in which injections of cash into an economy by a central bank fail to lower interest rates and hence to stimulate economic growth. A liquidity trap is caused when people hoard cash because they expect an adverse event such as...

 where, they argue, crowding out is minimal.

Some classical
Classical economics
Classical economics is widely regarded as the first modern school of economic thought. Its major developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John Stuart Mill....

 and neoclassical economists
Neoclassical economics
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits...

 argue that crowding out completely negates any fiscal stimulus; this is known as the Treasury View
Treasury View
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...

 , which Keynesian economics rejects. The Treasury View refers to the theoretical positions of classical economists in the British Treasury, who opposed Keynes' call in the 1930s for fiscal stimulus. The same general argument has been repeated by some neoclassical economists up to the present.

In the classical view, the 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 causes that country's currency to appreciate. Once the currency appreciates, goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. Consequently, exports decrease and imports increase.

Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy, and inflationary effects driven by increased demand. 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.

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. The term probably originated from the definition of straitjacket
Straitjacket
A straitjacket is a garment shaped like a jacket with overlong sleeves and is typically used to restrain a person who may otherwise cause harm to themselves or others. Once the arms are inserted into the straitjacket's sleeves, they are then crossed across the chest...

: anything that severely confines, constricts, or hinders. Various states in the United States
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...

 have various forms of self-imposed fiscal straitjackets.

See also

  • Functional finance
    Functional finance
    Functional finance is an economic theory proposed by Abba P. Lerner, based on effective demand principle and chartalism. It states that government should finance itself to meet explicit goals, such as taming the business cycle, achieving full employment, ensuring growth and low inflation.-...

  • National fiscal policy response to the late 2000s recession
    National fiscal policy response to the late 2000s recession
    Many nations of the world have enacted fiscal stimulus plans in response to the global, ongoing recession. These nations have used different combinations of government spending and tax cuts to boost their sagging economies...

  • Fiscal union
    Fiscal union
    Fiscal union is the integration of the fiscal policy of nations or states. Under fiscal union decisions about the collection and expenditure of taxes are taken by common institutions, shared by the participating governments...

  • Fiscal policy of the United States
  • Interaction between monetary and fiscal policies
    Interaction between monetary and fiscal policies
    Fiscal policy and monetary policy are the two tools used by the State to achieve its macroeconomic objectives. While the main objective of fiscal policy is to increase the aggregate output of the economy, the main objective of the monetary policies is to control the interest and inflation rates...


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