Understanding Fiscal Policy

Understanding Fiscal

Government expenditures are captured under the fiscal policy. This is a policy that handles government spending and taxation when it wants to influence the economy. The economic cycle is a normal phenomenon that affects every government. When the demand for goods and services in an economy is low, the government will employ various policies to bring it up. And when it is too high, the government will also use various approaches to bring it back to the normal balance. In other words, governments apply the fiscal policy when they want to influence the level of aggregate demand in the economy. With these approaches, they try to achieve different economic objectives for price stability, more employment opportunities, and their economies' general growth.

Creating Fiscal Policy

The government leverages two aspects of the economy when creating fiscal policies. The first one is that it can change the level and composition of taxation. This means the government can either increase or reduce taxes on various goods to meet its economic growth and development targets. Taxing is reduced during a recession to allow people to gain more profits from their businesses. And when the economy is booming, taxes can be increased to increase government spending or discourage more negative growth, which can affect an economy's general health. Secondly, the government can change the level of spending in various sectors of the economy. For instance, during the 2008-2009 great recession, many governments opted to spend in certain failing markets through bonds and loans, helping them get back on track. The government may also choose to invest more in education by building more schools or in the health sector by offering more coverage for its people. Every step taken is to help shape the economy in a specific direction.

Fiscal policy may not be acceptable before every economist, as there are some who think the government intervention only makes things worse. For instance, taking funds from the private sectors, which many see as the driver of economies, does not seem logical to some economists. Therefore, it is a highly debatable subject, yet one that carries great significance for every economy.

Fiscal policy is presented in three main approaches:

Neutral fiscal policy

We can simply understand fiscal policy as to where the government spends tax payer's money during different economic phases. It seeks to bring things to a normal and sustainable growth that can be well handled. If things are left to run as they would without such interventions, they will end up bad for the government.

An economy that does not have specified laws for dealing with economic issues is bound to fail. And so is the one where no one knows how, when, and why to apply the set policy. We have said that an economy can either be high, low or at equilibrium at any given time.

When the economy is neither booming nor recessing, it is said to be neutral. In this case, the government expenditure is funded entirely by the revenue that comes from taxes. This has a neutral effect on the level of economic activity. Neutral fiscal policy does not seek to boost or reduce economic growth but to keep things floating on a neutral level.

Expansionary fiscal policy

During the great recession, governments adopted a different approach to awaken the economy. These approaches are what we call expansionary fiscal policy. As you may have already guessed from the title, expansionary seeks to expand the economy, which is why it comes during a recession. Here, the government spends more money than the revenues collected from taxes. Policymakers will have already made other decisions liken reducing taxes and lending rates. Even the money that comes from tariffs and printing money is not enough to supplement this spending. As such, the government is left with not much option but to borrow funds from internal and external bodies.

Contractionary Fiscal Policy

The opposite of expansionary fiscal policy is contractionary. Every that happens during the expansion is reversed. At this point, the government is looking to pay down government debt and to cap inflation. Taxation is increase as well as the lending rates. As if that is not enough, the government reduces its expenditure compared to the tax revenue.

 Economic recessions and expansions are the two main aspects of the economy that attract a lot of varying opinions in terms of policies. For instance, during recessions, Keynesian economics argues that the government should increase spending and reduce tax rates as the best to stimulate positive growth. Supporters of this theory hold that this approach is necessary during a recession or when the economic activity is low as it creates incentives for turning back. It forms a strong foundation for economic growth and proper working towards creating full employment. And this means the government will have to borrow funds from other sources, which builds public debt. Theoretically, the deficit that comes from it will be paid back during the expansion period. It is assumed that stimulating the economy can lead to a boom, which can be used to pay back all, or part of the debt until the next equilibrium or recession.

When the economy is booming, Keynesians hold that reducing government spending will reduce the rate of aggregate demand and contract the economy. Doing this will stabilize prices, especially when inflation is too high. The most important point here is that the government always has to react to different economic situations.

It comes down to how the government uses revenues that come from tax collection. In this case, the government cannot spend more when investing or paying back the public debt. At the same time, it cannot stop spending when it is time to boost the economy. In any case, it is the fiscal policy that forms the foundation of decisions to be made.

Fiscal Policy and AD-AS Model

Using the expansionary policy changes the direction of aggregate demand, taking it to the left, while contractionary fiscal policy moves it to the left. Considering this, another important approach to understanding fiscal policy is by looking at what these shifts mean to the general economy. The government takes action spending and taxation very seriously when coming up with the fiscal policy. These are the actions that lead to either decreasing or increasing the aggregate demand.

Note that aggregate demand is divided into four main parts: consumption, investment, government spending, and net exports. These are the main factors that affect a country's GDP. Fiscal policy is the pillar of these parts of economic activity. It will come into kick-start the economy during a recession, in which case it encourages more aggregate demand. This, in turn, leads to increase output and employment within the economy. It is worth noting that we live in a world where natural resources are limited, yet they are expected to meet human beings' unlimited needs. Constant issues like population, pollution, and many others continue to threaten the few resources that we have. It's, therefore, upon the government to ensure that these limited resources are well distributed.

Hence, when applying the expansionary policy, the government needs to increase spending, reduce taxes, or do both simultaneously. Aggregate demand is defined by many components, among them government spending. Therefore, when there is an increase in government expenditure, it shifts the demand curve to the right, as stated above. And where there is reduced taxation, there is more room for disposable income, causing and increasing consumption and saving.

Let step back a bit and look at the economic theory. The consumer will spend their money depending on what is more important in their life and how much supply there is for that material. Human beings are considered rational decision-makers by the consumption theory, where anything that does not add value to the current state is toast aside. The issue of scarcity comes into the picture here again. That as much as we all may want to spend money on everything we want, there is only too little to use on what we need only. When the economy is low, households will spend less and save more, negatively affecting the GDP. Hence, the government tries to spend more, reducing prices and taxes to encourage more spending and less saving, which boosts the economy.  

On a scale, any increase in government spending together with reduced taxing also takes the AD curve to the right. The shift will extend as far as the size of the spending multiplier, whereas the shift in the AD curve responding to tax reduction depends on the text multiplier. A deficit is created if the government spends more than what it budgeted for, which leads to public debt.

Now something about the contractionary fiscal policy. We already know that it's applied when there is demand-pull inflation. In other words, there is more demand than there is supply, which creates price inflation and other negative effects on the economy. It is upon the government to make informative decisions that bring back the economy to a normal state. The contractionary fiscal policy is the answer to this problem. It can also be implanted when dealing with unwanted debt.

When using contractionary policy, the government can employ different techniques, decreasing spending, raising taxes, or combining the two. This policy takes the AD curve to the left. When the tax revenues go beyond government spending, it creates what is known as a budget surplus, which is simply having more money than the government can spend.

Using expansionary and contractionary policies – similarities and differences

According to Keynesian theories, the decisions made by the private sector may sometimes lead to insufficient macroeconomic results, in which case, certain active policy responses need to be applied by the public sector. This is done to stabilize output over the business cycle. The countercyclical fiscal policies, which acted against the tide of the business cycle, was highly advocated for by Keynes. In other words, deficit spending and more taxes when the economy is facing a recession and less spending in governments and higher taxes during the boom times are the most effective approaches.

This theory also holds that if there is less than potential output in the economy, government expenditure can be applied, putting idle resources into use, which in turn boosts the output. There will be more aggregate demand, which then leads to an increase in the GDP, raising prices. This is what defines the expansionary policy. Contrastingly, when the economy is facing and expansion, the government will need to use the contractionary policy. Here, spending is decreased, in turn increasing aggregate demand and the real GDP. As a result, there is a decrease in prices.    

The government does not need to make up for the whole gap during a recession. A multiplier effect is applied to impact how the government should spend. For instance, it can stimulate a wide range of new productions and modest expenditure if people spend more than they earn. With extra spending, businesses are able to hire more people and pay them easily, which further increases spending. Apart from changing spending, the government can also decrease income taxes to try and close the recession gap. This increases aggregate demand and the real GDP, raising prices in the end.

Crowding out is the biggest limitation of the fiscal policy. This happens when the government spending simply takes over the output from the private sector instead of encouraging it for more output to the economy. This happens when the government raises interest rates too high, limiting investment.


Expenditure and tax revenues are the two main levers governments use to set fiscal policy. They come in the form of expansionary policy where the government increases spending, reduces taxes, uses both, and contractionaryUnderstanding Fiscal, which features less government spending and increased taxes. All these methods are used because the government needs to put the economy on the right path for growth and development. The government spending multiplier is a figure that shows how much change in the aggregate demand will affect spending. The tax multiplier is smaller than the spending multiplier.                                                                           


1994 Words


May 12, 2021


4 Pages

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