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Fiscal policy


Fiscal policy
In economics and political science, fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy.[1] The two main instruments of fiscal policy are government taxation and expenditure. Changes in the level and composition of taxation and government spending can impact the following variables in the economy: € Aggregate demand and the level of economic activity; € The pattern of resource allocation; € The distribution of income. Fiscal policy refers to the use of the government budget to influence economic activity.

Stances of fiscal policy
The three main stances of fiscal policy are: € Neutral fiscal policy is usually undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity. € Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions. € Contractionary fiscal policy occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt. However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance.

Methods of funding
Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways: € € € € € Taxation Seigniorage, the benefit from printing money Borrowing money from the population or from abroad Consumption of fiscal reserves Sale of fixed assets (e.g., land)

full employment. whether government borrowing leads to higher interest rates that may offset the stimulative impact of spending. Some classical and neoclassical economists argue that crowding out completely negates any fiscal stimulus. goods originating from that country now cost more to foreigners than they did before and foreign goods now cost less than they did before. The same general argument has been repeated by some neoclassical economists up to the present. like treasury bills or consols and gilt-edged securities. the resulting deficits would be paid for by an expanded economy during the boom that would follow. crowding out is minimal. Keynesian economics suggests that increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand. Public debt or borrowing : it refers to the government borrowing from the public. because government borrowing creates higher demand for credit in the financial markets. In theory. When governments fund a deficit with the issuing of government bonds. and may be invested in either local currency or any financial instrument that may be traded later once resources are needed.Fiscal policy 2 Borrowing A fiscal deficit is often funded by issuing bonds. demand for that country's currency increases.[2] . 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. this is known as the Treasury View . or monetizing the debt. The Treasury View refers to the theoretical positions of classical economists in the British Treasury. and decreasing spending & increasing taxes after the economic boom begins. interest rates can increase across the market. When the government runs a budget deficit. exports decrease and imports increase. In the classical view. Therefore. additional debt is not needed. In other words. they argue. the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. this was the reasoning behind the New Deal. Governments can use a budget surplus to do two things: to slow the pace of strong economic growth. Consuming prior surpluses A fiscal surplus is often saved for future use. contrary to the objective of a fiscal stimulus. all other things being equal. Economists debate the effectiveness of fiscal stimulus. and to stabilize prices when inflation is too high. The argument mostly centers on crowding out. Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy. When government borrowing increases interest rates it attracts foreign capital from foreign investors. who opposed Keynes' call in the 1930s for fiscal stimulus. Economic effects of fiscal policy Governments use fiscal policy to influence the level of aggregate demand in the economy. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective especially in a liquidity trap where. These pay interest. the expansionary fiscal policy also decreases net exports. This causes a lower aggregate demand for goods and services. the marginal propensity to save needs to be strictly positive. thus stabilizing prices. Once the currency appreciates. which Keynesian economics rejects. which has a mitigating effect on national output and income. and economic growth. notice. For this to happen. The increased demand causes that country's currency to appreciate. either for a fixed period or indefinitely. a nation may default on its debts. companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. overseas borrowing. funds will need to come from public borrowing (the issue of government bonds). Consequently. This is because. If the interest and capital requirements are too large. foreign investors must obtain that country's currency. in an effort to achieve economic objectives of price stability. when foreign capital flows into the country undergoing fiscal expansion. To purchase bonds originating from a certain country. usually to foreign creditors.

P. to limit or regulate the budget deficit over a time fiscal_policy_criticism. Upper Saddle River. ISBN•0-13-063085-3. com/ pearsonschool. External links € Concise Encyclopedia of Economics (http://www. and inflationary effects driven by increased demand. fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. J. leading to wage inflation and therefore price inflation.. org/ library/ Enc/ FiscalPolicy. html [3] http:/ / dictionary.asp) . the stimulus is increasing labor demand while labor supply remains fixed.[3] Various states in the United States have various forms of self-imposed fiscal straitjackets. however. [2] http:/ / www. In theory. Arthur. P. New Jersey 07458: Pearson Prentice Hall. Boettke. if the stimulus employs a worker who otherwise would have had a or policy Other possible problems with fiscal stimulus include the time lag between the implementation of the policy and detectable effects in the economy. References [1] O' Sullivan. For instance. (2002): The Economic Way of Thinking (10th ed).economicshelp..bized. € Larch.An Assessment of Current Practice and Challenges. if a fiscal stimulus employs a worker who otherwise would have been unemployed. Sheffrin (2003). com/ browse/ straitjacket Bibliography € Heyne. 3 Fiscal Straitjacket The concept of a fiscal straitjacket is a general economic principle that suggests strict constraints on government spending and public sector borrowing. Nogueira Martins (2009): Fiscal Policy Making in the European Union . cfm?locator=PSZ16o& PMDbSiteId=2781& PMDbSolutionId=6724& PMDbSubSolutionId=& PMDbCategoryId=815& PMDbSubCategoryId=& PMDbSubjectAreaId=& PMDbProgramId=5657& PMDbProductId=5475). and J.•387. L.econlib. constricts.investopedia.htm) € Limitations of Fiscal Policy (http://www. pp. econlib. there is no inflationary effect. Prychitko. . Steven M. The term probably originated from the definition of straitjacket: anything that severely confines.html) € What Is Fiscal Policy? (http://www. T.html) € Using Fiscal Policy (http://www. Economics: Principles in action (http:/ / www. Routledge. reference. D. Prentice Hall.

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