a change in the desire to save causes a change in investment. Thus, said Keynes, classical economists had gotten things backwards. (Jhinghan, 1998)
Part B: Essay (30 marks)
What are the costs and benefits of using fiscal policy to manage an economy’s short-term and long term growth rates? Discuss.
Introduction
Many early enthusiasts of the Keynesian approach believed that fiscal policy was like a knob they could turn to control the pace of the economy. A bigger budget deficit meant more stimulus for economic growth, which could lower unemployment and pull the economy out of recession. A smaller budget deficit or a budget surplus could slow down an overheated economy and dampen the threat of inflation.
This review will analyze the major ways in which the government can employ fiscal policy and we will examine the practical shortcomings that have become apparent.
Fiscal Policy
Fiscal policy is the process of shaping taxation and government expenditure to influence Aggregate Demand (AD) and therefore the level of economic activity (Jinghan, 1998). More precisely, Fiscal policy involves the Government changing the levels of Taxation and Government Spending in order to dampen the swings of the business cycle and contribute to the maintenance of a growing, high-employment economy, free from high or volatile inflation.
AD = C+ I + G + X – M
Where,
AD= Aggregate Demand
C= Consumption expenditure
I= Investment demand
G= Government purchases of goods and services
X= Export
M = Import
Fiscal policy can be either discretionary or automatic. Discretionary fiscal policy is initiated by an Act of Parliament. Discretionary fiscal policy requires purposeful actions by the government in response to changing economic conditions. For example, increasing tax rate or defense expenditures are discretionary policies. On the other hand, automatic fiscal policy is triggered by the state of the economy. All through the day and night, whether or not parliament is in session, taxes and spending are stabilizing the economy. For example, increase of unemployment triggers automatic increase of payments to the unemployed (McTaggart et al, 2010).
The Benefits of Fiscal Policy
Fiscal policy stabilizes the real GDP by stabilizing AD. Countercyclical fiscal policy is sometimes used in discretionary programs which include public works, jobs programs, and various tax programs. Public works involve such long time lags in getting under way as to make their use for combating short recession impractical (McTaggart et al, 2010). Most macroeconomist believe that monetary policy is more useful than fiscal policy for combating short-term fluctuations of the business cycle (Jinghan, 1998).
Basically fiscal policy aims to stabilize economic growth avoiding the boom and bust economic cycle. It reduces the rate of inflation and stimulates the economic growth in a period of recession. Figure 1 illustrates how discretionary fiscal policy can be used to eliminate inflationary recession (McTaggart et al, 2010).
Figure 1: Expansionary Fiscal Policy (McTaggert et al, 2010)
Fiscal stance refers to whether the government is increasing AD or decreasing AD. Expansionary fiscal policy involves increasing AD. Therefore the government will increase spending (G) and cut taxes. Lower taxes will increase consumers spending because they have more disposable income(C). This will worsen the government budget deficit. On the other hand, deflationary fiscal policy involves decreasing AD. Therefore the government will cut spending (G) and or increase taxes. Higher taxes will reduce consumer spending (C). This will lead to an improvement in the government budget deficit (Jinghan, 1998).
Discretionary fiscal stabilizers are a deliberate attempt by the government to affect AD and stabilize the economy, for instance, in a boom the government will increase taxes to reduce inflation. Injections (J) are an increase of expenditure into the circular flow; it includes government spending (G), Exports (X) and Investment (I). Withdrawals (W) are leakages from the circular flow. This is household income that is not spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M) (Jinghan, 1998).
Fine Tuning involves maintaining a steady rate of economic growth through using fiscal policy. However this has proved quite difficult to achieve precisely (Jinghan, 1998).
Limitations of Discretionary Fiscal Policy
Fiscal Policy was particularly used in the 50s and 60s to stabilize economic cycles. These policies were broadly referred to as 'Keynesian' In the 1970s and 80s governments tended to prefer monetary policy for influencing the economy. There are many factors which make successful implementation of fiscal Policy difficult (Jinghan, 1998).
- Increasing Taxes to reduce AD may cause disincentives to work, if this occurs there will be a fall in productivity and aggregate supply (AS) could fall. However higher taxes do not necessarily reduce incentives to work if the income effect dominates (Jinghan, 1998).
- Reduced government spending to Increase AD could adversely affect public services such as public transport and education causing market failure and social inefficiency (Jinghan, 1998).
- Fiscal policy will suffer if the government has poor information. For example, if the government believes there is going to be a recession, they will increase AD, however if this forecast was wrong and the economy grew too fast, the government action would cause inflation (Jinghan, 1998).
- If the government plans to increase spending this can take a long time to filter into the economy and it may be too late. Spending plans are only set once a year. There is also a delay in implementing any changes to spending patterns (Jinghan, 1998).
- Expansionary fiscal policy (cutting taxes and increasing G) will cause an increase in the budget deficit which has many adverse effects. Higher budget deficit will require higher taxes in the future and may cause crowding out (see below) (Jinghan, 1998).
- If the government uses fiscal policy its effectiveness will also depend upon the other components of AD, for example if consumer confidence is very low, reducing taxes may not lead to an increase in consumer spending (Jinghan, 1998).
- In injections may be increased by the multiplier effect, therefore the size of the multiplier will be significant (Jinghan, 1998).
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Increased Government spending (G) to increased AD may cause “Crowding out”. Crowding out occurs when increased government spending results in decreasing the size of the private sector (Jinghan, 1998).
- For example if the government increase spending it will have to increase taxes or sell bonds and borrow money, both method reduce private consumption or investment. If this occurs AD will not increase or increase only very slowly (Jinghan, 1998).
- Also Classical economists argue that the government is more inefficient in spending money than the private sector therefore there will be a decline in economic welfare (Jinghan, 1998).
- Increased government borrowing can also put upward pressure on interest rates. To borrow more money the interest rate on bonds may have to rise, causing slower growth in the rest of the economy (Jinghan, 1998).
- Monetarists argue that in the long run aggregate supply (AS) is inelastic therefore an increase in AD will only cause inflation to increase. (Jinghan, 1998).
Automatic Fiscal Stabilizers
Tax revenue that vary with national product (NP) are therefore an automatic stabilizer. The way that taxes act to stabilize the economy is illustrated in figure 2. In this diagram, taxes (T) are just adequate to cover government expenditure (G) when the economy is at full employment national product NP1; the budget is balanced (G=T). Now suppose the economy slips into a recession, with NP decreasing to NP2. Tax collections fall, and the budget automatically moves into deficit. This fall in tax collections helps to keep up aggregate demand: Disposable income is left in the hands of the public, and consumption therefore falls less sharply than it would in a tax-free economy. Thus, the downward momentum in the economy is reduced. Similarly, the tax system acts as a restraint on an upswing. As national product increases, tax collections rise. The government’s budget moves toward surplus, and the upward movement of the economy is slowed down (Jinghan, 1998).
There are also automatic stabilizers on the government expenditures side (not shown in figure 2). Unemployment insurance compensation and welfare expenditures
Automatic Fiscal stabilization (Jinghan, 1998)
automatically rise during a recession, sustaining disposable incomes and slowing the downswing.
Automatic stabilizers reduce the severity of economic fluctuations. But they do not eliminate them. The objective of discretionary fiscal policy is to reduce the fluctuations even more (Jinghan, 1998).
Limitations of Automatic Stabilizers
Automatic stabilizers avoid some of the problems of discretionary fiscal policy, but they can not completely smooth out the ups and downs of the business cycle. To see why, consider the example of taxes. A shock to spending will have a multiplied impact on output. However, the automatic tendency of taxes to take away a fraction of each extra dollar of income reduces the size of the multiplier. The cyclical sensitivity of taxes is like a shock absorber that reduces the impact of shocks and helps stabilize the economy (Jinghan, 1998).
Automatic stabilizers act to reduce business –cycle fluctuations in part, but they can not wipe out all of the disturbances. Whether to reduce the remaining disturbance, and how, remains the task of discretionary monetary and fiscal policy (Jinghan, 1998).
Conclusion
The principal purpose of this review was to explain the cost and benefits of using fiscal policy to manage an economy’s short-term and long term growth rates. The government has the ability and the responsibility to manage aggregate demand and thus to ensure a continuing growth without inflation. The government can affect aggregate demand with fiscal policies, that is, by changes in government spending or tax rates.
Reference:
Brooks, R. & Fuasten, D. (1998). Australia’s Foreign Debt. In Macroeconomics in the open economy. Addison Wesley Longman, South Melbourne.
Krayger, T. (1996). Research Note. Parliamentary Research Service. Retrieved from www.aph.gov.au/library/pubs/rn/1995-96/96rn40.pdf
Harris, N. (2001). Business economics: Theory and applications. UK: Butterworth Heinmann.
Jhinghan, C. (1998). Macroeconomics. Mc-Graw-Hill Book Company, New Delhi.
McTaggart, D., Findlay, C. & Parkin, M. (2010).Economics, Pearson Australia, 2010.
Tregarthen, I., & Rittenberg, L. (2000). Economics (2nd ed.). USA: Worth.