Fiscal policies are carried out by the legislative and sometimes, the executive branch of the government. The two main instruments of fiscal policy are taxes and government expenditure. The government amasses taxes to finance its expenditures. Therefore, fiscal policy can affect production and may be used as an instrument for economic stabilization. It can either be contractionary or expansionary.
The Government Budget
A government budget is a document prepared by a political entity. A budget presents the amount of revenue the political entity aims to raise and the modalities it will use to raise it. Above all, a budget proposes how the revenue would be spent in the coming financial year.
Budget Deficit
A government’s expense can surpass its revenue in a financial year creating a budget deficit. A budget deficit is a negative difference between expenditures and tax revenues for a fixed period of time. The government finances the budget deficit by borrowing when it issues long-term and interest-bearing bonds. These outstanding bonds and payments are known as the national debt.
Budget Surplus
When government expenditures are less than the tax revenues in any given financial year, the government runs on a budget surplus during that particular year. The surplus is simply the difference between government expenditure and tax revenues.
Balanced Budget
When revenues and government expenditures are equal, the government will run on a balanced budget during the financial year in question.
During a recession, the government employs idle resources and tries to boost economic output. This increased spending increases aggregate demand, hence, a higher real GDP. This is referred to as an expansionary fiscal policy. It is usually an attempt to raise employment rates and output. The expansionary policy includes:
- deficit spending;
- tax cuts; and/or
- subsidies.
Contractionary Fiscal Policy
Contractionary fiscal policy is explained as a decline in government expenditure. Alternatively, it can be defined as a raise in taxes that causes the government’s budget surplus to increase, or its budget deficit to decrease. A budget deficit or surplus usually determines the type of fiscal policy either as contractionary or expansionary. Contractionary fiscal policy includes:
- budget surplus; and/or
- increased tax rates.
Question
Which one of the following is least likely a reason to use fiscal deficits as an expansionary tool?
- The government may be crowding out private investments.
- The government may facilitate tax changes to reduce distortions in the economy.
- The government may stimulate employment when there is substantial unemployment in the economy.
Solution
The correct answer is A.
A common argument against raises in fiscal deficits is that the additional borrowing to fund the deficit in the financial markets will displace private-sector borrowing that would otherwise be invested by corporations that would create economic growth. This is referred to as “crowding-out.”
B and C are incorrect. They are the reasons to use budget deficits.
By the end of this section, you will be able to:
- Explain how expansionary fiscal policy can shift aggregate demand and influence the economy
- Explain how contractionary fiscal policy can shift aggregate demand and influence the economy
Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. We know from the chapter on economic growth that over time the quantity and quality of our resources grow as the population and thus the labor force get larger, as businesses invest in new capital, and as technology improves. The result of this is regular shifts to the right of the aggregate supply curves, as Figure illustrates.
The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.
Aggregate demand and aggregate supply do not always move neatly together. Think about what causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in any given period it may not shift the same amount as aggregate supply. What happens to government spending and taxes? Government spends to pay for the ordinary business of government- items such as national defense, social security, and healthcare, as Figure shows. Tax revenues, in part, pay for these expenditures. The result may be an increase in aggregate demand more than or less than the increase in aggregate supply. Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes.
For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use fiscal policy to address the difference.
Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the money supply, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.