Macroeconomics – Fiscal policy

A country’s GDP is comprised of various spending activities that are mainly classified into four categories – consumption, investment, government purchases and net exports – in national income accounts (Mankiw, 2002). To control the effects of these to the economy one of the policy options available to the government is the fiscal policy which is implemented through alteration of taxation levels and government expenditure (Mankiw, 2002).

Fiscal Policy Tools

Government spending forms a major component of a country’s GDP. Governments for instance spend on infrastructure development, security, education, health and other sectors of the economy. The purchase that the government makes in providing these services impact on the economy’s output hence affects the demand in the market (Mankiw, 2002). By altering their expenditure programs in accordance to prevailing economic conditions, governments can affect aggregate demand (Mankiw, 2002). Apart from government expenditure that is carried out in exchange for goods and services, other expenditures such as transfer payments exemplified by the welfare programs could also indirectly influence the demand for goods and services. Such transfers for instance provide households with increased disposable income thus motivating their propensity to spend (Mankiw, 2002). Transfers thus have an opposite effect to taxation in influencing the demand for goods and services in the economy.

Taxation forms the second tool through which governments implement their fiscal policies. Various taxes such as income tax, value added tax, custom taxes, and corporation taxes may be levied by the government (Mankiw, 2002). By altering the rates at which these taxes are levied in accordance to the prevailing economic environment, governments influence aspects such as consumption and investment thus affecting aggregate demand (Colander, 2008). When the government for instance increase rates on income taxes, the available disposable incomes to households is decreased thus reducing their purchasing power (Mankiw, 2002). Similarly increasing taxes on goods would increase their prices thus reducing the quantity that a given amount of currency can purchase (Mankiw, 2002). Since household incomes may not increase at the same rate as the product prices, consumers would thus be cautious in their spending hence reducing the demand for some of the products in the economy. By altering its expenditure and taxation programs the government could thus influence the aggregate demand for goods and services in the market.

To express its expenditure and taxation programs to the public, the government prepares annual budgets that are usually presented to the House of Representatives for approval. When the governments’ planned purchases equal taxes less transfer payments, the budget presented is said to be balanced (Mankiw, 2002). Often however, the government budgeted purchases may exceed its projected tax revenues thus resulting into a budget deficit (Mankiw, 2002). In such a case the deficit is funded by borrowing through issuance of government debt in the financial market (Mankiw, 2002). When projected tax revenues exceed the expected expenditure, a budget surplus scenario arises, according the government extra funds that it can use in financing its outstanding debt (Mankiw, 2002).

Reasons for Using Fiscal Policy Tools

The fiscal policy can be used to bring about equilibrium to the demand and supply in the economy. When demand outstrips the supply then such would result into an inflationary trend if not curbed and eventually lead to prices of commodities getting out of hand. Conversely when the supply supersedes the demand, a deflationary trend would follow thus leading to very low prices of goods and services in the economy. Such low prices could adversely affect the incomes for businesses thus affecting their capacity to hire workforce hence ultimately raising unemployment levels in the country. The fiscal policy can thus be used to control demand and supply and in so doing establish a relative price stability, and employment level in the economy. The government thus alters its fiscal policy in accordance with the prevailing conditions to either spur the economy in times of slow downs by increased spending or reduce consumer spending when it threatens to drive the economy towards inflation.

Various economic situations may be addressed through fiscal policy initiatives. When aggregate income is too low an expansionary fiscal policy would help increase aggregate demand (Colander, 2008). Such expansionary policy is followed by increasing budget deficits through lower taxes and/ or higher government spending (Colander, 2008). Conversely, in the event the aggregate incomes are too high, a contractionary fiscal policy would lower the aggregate demand (Colander, 2008). The contractionary policy is effected by decreasing the budget deficit through tax increment and/or reduced government spending.

Illustration: Use of AD/AS model in expansionary and contractionary fiscal policies

fiscal policy


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