What is Fiscal Policy?

“The great thing about fiscal policy is that it has a direct impact and doesn't require you to bind the hands of future policymakers.”

- Paul Krugman

 

There are multiple economic conditions that prevail and impact the country from time to time. When an economy booms or expands these conditions are said to be positive and sound whereas when an economy faces contraction or downfall these conditions are considered adverse and negative.

 

These economic conditions are impacted by various macro and micro factors including fiscal policy and monetary policy as well as unemployment, exchange rate fluctuations, inflation etc.

 

Economists and analysts measure these economic conditions from time to time to understand their effect on the economy. Government also intervenes to minimize the adverse effects. In this blog you will learn about Fiscal Policies.

 

Also Read | 4 Types of Economic Activities

 

History & Concept of Fiscal Policy

 

It was John Keynes, a British Economist, whose ideas were the basis of forming Fiscal Policies. He proposed that recession in an economy is caused by the deficiency in consumer spending and investment by business. 

 

It was the Great Depression that led him to create such theories. His ideas influenced the US so much that they increased their expenditure on social welfare and public projects. The New Deal in the US led to the improvement of the US economy from the Great Depression. 

 

He believed that the government has the power to intervene and stabilize the cycle and create an order by correcting the spending and improving the tax deficiencies to regulate the shortfalls in the private sector.

 

According to him, the private sector can take decisions that can cause adverse or inefficient outcomes. In order to correct them, the private sector has to intervene and stabilize the whole situation.

 

If an economy is producing less than required or not working at its full potential, we can increase the government spending and use the idle resources to boost the output. It can be done by adopting Fiscal Policies. 

 

Fiscal Policy is using government spending and tax to influence an economy. Government uses fiscal policies to reduce poverty, maintain sustainable economic conditions.

 

When the government changes the spending and taxes it will create an impact on the Aggregate demand. Basically the aggregate demand has four different components namely-  Consumption, Investment, Government expenditure and net of exports. A change in any one will cause changes in Aggregate Demand as well.

 

Working of Fiscal Policies

 

In order to create an impact on the economy, the government uses two approaches- monetary policies and fiscal policies. Government changes the tax rates, levels of taxes, spending options, and even borrowing options. In short, the government can directly and indirectly influence the use of resources in an economy.

 

When we calculate the national income or Aggregate Demand i.e. AD using expenditure method, we use the following formula:

 

GDP=C+I+G+X-M

 

In this formula we can see how the government can influence the GDP by impacting the consumer expenditure (C), as well the investments (I). Government also has direct control on G. If the fiscal policy increases the AD by increasing G then it is expanding, otherwise it is contracting if AD is reduced.

 

Also Read | Understanding Gross National Income

 

 

Types of Fiscal Policies

 

When government adopts fiscal policies it can make two decisions that are:

 

1. Either to change the taxation policies, rates and levels. 

 

Or,

 

2. Change the spending level of economic sectors.

 

Based on these changes we have 3 different types of fiscal policies. 

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Types of Fiscal Policies

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1. Neutral

 

When an economy is at equilibrium we can use Neutral Fiscal Policy. In this all the government expenditure is done through tax collected. It means there will be a neutral effect or no effect on the economic conditions. This policy is used very less as compared to the other two.

 

 

2. Expansionary

 

When an economy is under recession we use Expansionary Fiscal Policies. In order to increase economic activities like spending & expenditure. In this the government will spend more money than it has collected through taxes.

 

 

3. Contractionary

 

When the government has to pay its public debt and reduce inflation it will opt for Contractionary Fiscal Policies. In this the government will spend less than the tax revenue it has collected.

 

Also Read | Expansionary Fiscal Policy

 

 

Pros & Cons of Fiscal Policy

 

Even though Fiscal Policies help in eradicating adverse economic conditions they have certain limitations. Let us check out some advantages and disadvantages of Fiscal Policies.

 

“Much fiscal policy is implemented, not through spending increases, but through tax credits and other so-called tax expenditures. The markets should respond to them as they do spending cuts, with little contraction in economic activity."

 

- Alan Greenspan

 

Advantages

 

1. Fiscal Policies help in reducing the rate of unemployment by helping in cutting taxes and increasing spending. Cutting taxes means more income which means more demand. To cope with demand we need more production which will generate employment opportunities.

 

2. It helps in reducing the budget deficit. A deficit can impact the economy through increased debt, and the country has to go with contractionary policies. By reducing spending and increasing tax rates we can reduce the budget deficit.

 

3. It also helps in boosting the economy. Economic growth becomes faster through right fiscal policies as people will have more income to spend and invest.

 

Disadvantages

 

1. Conflicts are caused when there is a mix of different tools of fiscal policies. Lowering investments can slow down economic growth even when we want it to boom.

 

2. Fiscal policies have to be passed and approved by the legislation. It is a time taking process which leads to late implementation. Even when the government decides to increase spending it takes time to create an impact.

 

Also Read | Revenue Deficit

 

If a country’s economic conditions are worrisome then the government can intervene and make changes. They can adopt fiscal policies and, depending on the conditions, use a specific fiscal policy tool to control such adverse conditions and bring the economy back to normal.