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Fiscal policy refers to government policy that attempts to influence the direction of the economy through changes in government spending or taxes. Fiscal policy can be contrasted with the other main type of economic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the supply of money. 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:
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Fiscal policy refers to the overall effect of the budget outcome on economic activity. The three possible stances of fiscal policy are neutral, expansionary and contractionary:
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:
A fiscal deficit is often funded by issuing bonds, like treasury bills or [consols]. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too great, a nation may default on its debts, usually to foreign creditors.
Fiscal policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth. Keynesian economics suggests that adjusting government spending and tax rates, are the best ways to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. The government can implement these deficit-spending policies due to its size and prestige and stimulate trade. In theory, these deficits would be repaid for by an expanded economy during the boom that would follow, the basis for the New Deal.
During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian Theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.
Despite the importance of fiscal policy, a paradox exists. In the case of a government running a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a higher aggregate demand (AD) due to the lack of disposable income, contrary to the objective of a budget deficit. This concept is called crowding out. Alternatively, governments may increase government spending by funding major construction projects. This can also cause crowding out because of the lost opportunity for a private investor to undertake the same project. However, the effects of crowding out are usually not as large as the increase in GDP stemming from increased government spending.
Another problem is the time lag between the implementation of the policy, and visible effects seen in the economy. It is often contended that when an expansionary fiscal policy is implemented, by way of decrease in taxes, or increased consumption (keeping taxes at old level), it leads to increase in aggregate demand; however, an unchecked spiral in aggregate demand will lead to inflation. Hence, checks need to be kept in place.
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