What is Fiscal Policy?,igcse notes

Fiscal Policy

Fiscal policy refers to government policy that attempts to influence the direction of the economy through changes in government taxes or through some spending.

The two main instruments of fiscal policy are government spending and taxation.

Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

• Aggregate demand and the level of economic activity.
• The pattern of resource allocation.
• The distribution of income.

How Fiscal Policy works?

Scenario one: High rate of Inflation

High rate of inflation is caused by too much aggregate demand in the economy. Government will use deflationary fiscal policy. Government will try to influence aggregate demand by reducing its public spending. The government will spend less on construction of roads, bridges and other public spending and thus aggregate demand will fall. On the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable income out people’s pocket resulting in a lower demand.

Scenario two: Low rate of Inflation 

In an economic recession, aggregate demand, output and employment all tend to fall. Now the Government wants to increase employment in the economy, it can attempt to do so by increasing aggregate demand. The Government will increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so that people have more disposable income to spend and instigate demand in the economy.

Watch a Video

Problems with Fiscal Policy

Reduce incentive to work

Raising taxes on income and profits reduce work incentives, employment and economic growth. An effort to reduce aggregate demand may cause disincentives to work, if this occurs there will be a fall in productivity and Aggregate supply could fall.

Adverse effect of lowering Public Spending

Reduced govt spending to Increase Aggregate demand could adversely affect public services such as public transport and education causing market failure and social inefficiency.

‘Crowding out’ effect

With an increase in government expenditure, there will be greater competition for limited resources. This will offset private investments resulting in shrinking of the private sector.

Inaccurate forecasting

If the Government’s estimate or forecasting is wrong or inaccurate the Fiscal policy will suffer. For example, if a recession is expected and the government practices deficit budget, and yet the recession turns out to be a boom, this will cause inflation.

Implementation of the Policy

Planning for the spending is done once by most of the governments. If there is a delay in the implementation of the fiscal policy, it might reduce the effectiveness of the policy. Thus the time lag is important.