How Fiscal Policy Affects the GDP

Keynesian economics supports the use of fiscal policy to find solutions for depression and expansion in the economy. There are two approaches, expansionary and contractionary, which form the foundation of creating the fiscal policy. Understanding these policies is key to understanding and creating sustainable economic growth. We are living in a world where human needs keep growing, and the resources that should feed these needs keep reducing. As such, it is up to the government to make decisions that affect economic growth and impact the general environment.

When it comes to discovering how the government collects and spends money, fiscal policy is a major aspect that cannot be ignored. Even though there are those who feel like it not the best approach, many policymakers agree that it's an effective way of dealing with bubbles and recessions in the economy. It is all about balancing things in the markets, where everything depends on the relationship between suppliers and consumers. The government's role in economic growth is one of uttermost importance to the modern economist. And as a student of economics, this is the topic you need to take very seriously.

In this topic, we will be discussing the role of fiscal policy in the GDP. We have already seen the importance of public finance in general and what can happen if there are no proper plans on this issue in any economy. Every government strives to make a good environment for good living for the people under their leadership. Apart from political growth, sustainable economic development is another major function of these governments. And this means they will have to make various decisions to encourage this growth at any given time. Any economy that fails to understand the impact of public finance is doomed to fail.

What is fiscal policy?

There are many approaches to explaining what fiscal policy is and what it is not. Many of them are correct, but the main idea is that fiscal policy is how the government using taxation and expenditure to stimulate the economy. Let's take a step back on this and start with the consumption theory. It follows the assumption that people are rational decision-makers. Hence, when making decisions, they consider what is more important to their current needs. Scarcity has caused everyone to spend carefully. Therefore, the way households spend during an economic boom is very different from how they spend during a recession. Every economist knows that growth is dependent on consumption, supply, taxation, and government expenditure. These are the main pillar of a growing economy.

Household consumption is one of the main determinants of a nation's GDP. More spending leads to a bigger GDP, which is also an indication of positive growth in the economy. On the contrary, less spending households create fewer numbers in the GDP. When there is a recession, consumers feel less secure about the future, and therefore, they save more and spend less, which causes a low aggregate demand. At the same time, firms are afraid of producing more because no one will consume their goods, leading to low aggregate supply. On the contrary, when the economy is booming, consumers are more excited to spend that to save, and manufacturers make more goods to meet the aggregate demand.

So, what happens when there is a recession? The government steps in to boost the economy using different features of the fiscal policy. In other words, when the economy is producing less than its potential output, fiscal policy is used – and in this case, expansionary fiscal policy.

Expansionary and contractionary policies are the two aspects of the fiscal policy that governments employ. We can understand these policies from the Keynesian economics point of view.

Keynesianism holds that the private sector's decisions may sometimes lead to inefficiency in macroeconomic outcomes, which creates the need for an active policy response from the public sector to stabilize its impact over the business cycle. Keynes called for the counter-cyclical in fiscal policies, which acted against the wind of the business cycle. Hence, deficit spending and decreased taxes could be effective during a recession, and decreased government expenditure and higher taxes during a boom would restore the economy to normalcy.

If the economy is seen to produce less than potential output, government spending can be initiated by putting to use the idle resources and boosting the economy. More spending leads to more aggregate demand, which then boosts the GDP, raising the prices. This approach is called the expansionary fiscal policy.  On the other hand, when the economy is expanding rapidly, the government can use the contractionary policy. In this case, there is decreased spending, which creates a decrease in aggregate demand, and the GDP, ending in reduced prices.

Government spending does not necessarily make up for the whole gap during a recession. And this is why there is a multiplier effect that controls how much the government should spend. For instance, the government can stimulate a wide range of new products, with a moderate expenditure increase where most people spend all their money. With more spending initiated, businesses are able to employ more people with good wages. Hence, there is more spending, leading further into the virtuous circle.

Apart from changing these spending behaviors, the government can also decrease income taxes, which further reduces the aggregate demand and the real GDP, raising prices. Increasing income tax would be employed to close the expansionary gap, which leads to low aggregate demand, GDP, and then prices.

Even this fiscal policy is an excellent approach to dealing with these issues, it has its limitations, which much be understood and dealt with. The main downside of this approach is crowding out. This happens when the government replaces the output from the private sector instead of using more boost to the economy. This effect occurs when the government increases tax rates, discouraging investment. Many firms become afraid to join the markets because of these high taxes.

Spending and Taxation

Another important aspect of the fiscal policy and its effect on the GDP is spending and taxation. The government must spend money on different projects, which all lead to improving the economy. It uses these two levers when coming up with the fiscal policy. For the case of expansionary policy, the government will increase spending, cut taxes, or use a combination of both factors. And an increase in spending and reducing tax encourages more aggregate demand. However, we cannot tell exactly how much this increase will extend because it depends on the expenditure and tax multipliers.

The number that shows how much shift in aggregate would come from specific spending is known as the government spending multiplier. This effect comes out clearly, and an incremental increase in expenditure makes up for more income and consumption. In other words, more people will have jobs, and they will be using most of their earnings to buy different goods and services. On the other, the tax multiplier is an effect that magnifies changes in the tax on aggregate demand. If there is decreased taxation, there is a similar effect on income and consumption as increased government spending. Lower taxes mean more firms will be willing to enter the markets, employing more people as the existing ones increase production and create more jobs.

However, note that the tax multiplier is not the same as the spending multiplier – it's much smaller. The main reason for this is also associated with government spending. The government will direct-purchase something when it spends money, which shifts the full amount of the change caused by this spending to aggregate demand. But when the government reduces taxes, it influences an incased in disposable income. Part of this income will be spent on different goods, while the rest will be saved. And since money that is saved does not contribute anyhow to the multiplier effect, the tax multiplier remains lower.

Another difference is that the multiplier government spending multiplier is always represented by a positive number, where the tax multiplier is always negative. This is due to the inverse relationship that exists between taxes and aggregate demand. And an increase in tax cases a decrease in aggregate demand and vice versa. The tax reduction size spells the multiplier effect on the of a tax cut, the minimal possibility to spend, and the crowding effect.

Suppose there is more income, demand for money increases, which causes an increase in the interest rates. This is where crowding out occurs. It is literally when companies decide to exit the market because of the increased taxes. Hence, there is also the effect of reduced spending. We have already established spending as one of the four components of aggregate demand. This reduced investment spending enters to mitigate the increase in aggregate demand, which came due to lower taxes.

Every that happens in the economy has a solution, and the government plays a crucial role in finding these solutions. By applying the fiscal policy, the government makes sure that the economy is growing at a sustainable pace, avoiding inflation and other factors that affect economic growth. Government spending and taxation are the main sources of fiscal policy. As such, they play a huge role in understanding and improving the national GDP. Both developing and developed economies face these issues, and these use these approaches, among others, to restore order. An economy is considered to be growing based on its GDP. It can fluctuate from year to year due to various underlying factors, but it still remains majorly on the government to create that balance.

Fiscal Policy on GDP

Now that you understand what fiscal policy is, it should be easy to know its impacts on the GDP. These effects come from the fiscal multiplier.

The expansionary policy can affect the GDP through the fiscal multiplier. Do not confuse the fiscal multiplier with the monetary multiplier. This is a ratio of an alteration in the national income to the government expenditure change that causes its happening. When there is more one on the multiplier, it creates an enhanced effect on the national income called the multiplier effect. This effect comes up when an initial amount affecting government spending increases, leading to a higher income and consumption. This causes more increment in income, decreasing consumption further. More of this effect results in more national income, which goes beyond the initial incremental spending. This is to say, the first change in aggregate demand may alter the aggregate out, which is a multiple of the first change. The multiplier effect is not a new parameter in arguing the efficacy of government expenditure of tax relief in resolving recession issues.

Consider this: if a government spends about one million dollars in building a plant, this money does not get lost. Instead, it will be used to pay builders, to buy revenue supplies, and many other uses. Those receiving wages will earn more disposable income, which may increase their consumption. As a result, there will be a rise in an aggregated demand, incentivizing companies to make more products and even employ more people. If those who receive this spending use it as their income too, demand is raised and possibly a further raise on consumption, and so on. GDP increment is calculated as the sum of all increases the next income of every part involved. This comes from the building contractor to those who used the consumption as their income. The builder who receives the one million may pay eight hundred thousand to sub-contractors, which leaves them with two hundred dollars as their net income and a similar increase in the disposable income.

This process follows the line down through subcontractors to their employees. Each one will have an increment in their disposable income according to the work they may have performed. Each of these people will spend part of the money on consumer goods according to their marginal consumption propensity. This cycle will go on several times, causing a change in the GDP. And is how the government plays its role in economic growth, but applying the fiscal policy.

Fiscal policy and have a multiplier effect on the economy, with expansionary policy affecting the real GDP. On the other hand, the contractionary policy can lead to a reduction in the real GDP.