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Discuss the fiscal policy tools undertaken by the government to stabilize the economy
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Explain discretionary fiscal policy and its limitation
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Explain automatic stabilizers
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Differentiate between discretionary fiscal policy and automatic stabilizers
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Explain the concept of crowding out effect
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 variables in the economy including aggregate demand and real GDP.
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 suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing spending and increasing taxes after the economic boom begins. Keynesians argue this method 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.
Types of Fiscal Policy
Expansionary:
An increase in government purchases of goods and services, a decrease in net taxes, or some combination of two for the purpose of increasing aggregate demand and expanding real output
Contractionary:
A decrease in government purchases of goods and services, an increase in net taxes, or some combination of the two for the purpose of decreasing aggregate demand and thus controlling inflation.
Tools of Fiscal Policy
- Discretionary Fiscal Policy
- Automatic Stabilizers
Discretionary Fiscal Policy
A fiscal policy achieved through government intervention, as opposed to automatic stabilizers. Elective changes in government spending and taxation in response to changes in economic activity. For example, in a period of recession, the government might increase highway spending in order to stimulate aggregate demand. Discretionary fiscal policy is not automatic and is not mandated by law.
Automatic Stabilizers
Automatic stabilizers, without specific new legislation, increase (decrease) budget deficits during times of recessions (booms). They enact countercyclical policy without the lags associated with legislative policy changes. Examples include:
·Corporate Profits - Taxes on corporate profits go up substantially during boom times, and decline rapidly during times of recession.
·Progressive Income Taxes - Progressive taxation push people into higher income tax brackets during boom times, substantially increasing their tax bill and reducing government budget deficits (or increasing government surpluses). During recessions, many individuals fall into lower tax brackets or have no income tax liability. This increases the size of the government budget deficit (or reduces the surplus).
· The Unemployment Insurance (UI) Program - This program provides payments to greater numbers of people as unemployment increases during times of recession. At the same time, the taxes that contribute to UI will go down as employment decreases. These two effects will cause the government budget deficit to increase. During boom times, the program will automatically produce surpluses (or reduce deficits) as fewer benefits are paid due to lower unemployment and tax revenues increase due to greater employment.
Crowding Out Effect
What It Is:
The crowding out effect describes the idea that large volumes of government borrowing push up the real interest rate, making it difficult or close to impossible for individuals and small companies to obtain loans.
How It Works/Example:
The theory behind the crowding out effect assumes that governmental borrowing uses up a larger and larger proportion of the total supply of savings available for investment. Because demand for savings increases while supply stays the same, the price of money (the interest rate) goes up.
Crowding out begins to take effect when the interest rate level reaches a point at which only the government can afford to borrow. Unable to compete for loans under such circumstances, individuals and smaller-scale companies are forced (crowded) out of the market.
Why It Matters:
Because crowding out leads to decreases in private sector consumption and, therefore, slows economic growth, the crowding out effect should be a serious consideration for any government that plans to get an increasing percentage of its funding through the capital markets.
