Fiscal Policy
Topic Twenty-Five

Previous - Monetary Policy

Fiscal Policy

Fiscal policy is where the overall economic activity is manipulated through government intervention such as government spending and taxation. Unlike monetary policy which is implemented by the Central Bank, fiscal policy is implemented by the government.

Solving Economic Problems using Fiscal Policy:

When there are inflationary pressures in the economy, the government reduces its spending in order to curb inflation. The government also increases taxation to take money away from the public to achieve the same objective. This is what is referred to as contractionary fiscal policy. On the other hand, when there is slowness in the economy and the financial system, the government attempts to increase economic activity by increasing its spending and reducing taxation. This is what is known as expansionary fiscal policy. Therefore, the two instruments of fiscal policy are government spending and taxation and these are changed by the government in order to manipulate the money supply in the economy to solve for both inflationary and deflationary situations.

An increase in government spending or an expansionary fiscal policy is achieved by running a budget deficit because the spending usually exceeds the revenues of the government. On the other hand, a reduction in government spending or a contractionary fiscal policy is achieved by running a budget surplus because revenues usually exceed spending. A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). 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

The government will want to pursue expansionary fiscal policy in an attempt to solve for a recessionary situation. This can be done either by increasing its spending which may take the form of the constructions of more roads, schools, bridges, etc. or a reduction in taxes. In this case, the IS Curve will shift to the right from IS1 to IS2 as in the graph below. The effect will be an increase in income from Y1 to Y2 and a rise in the rate of interest from i1 to i2. This rise in the interest rate will lead to a decline in investments and hence a fall in the overall economic activity. The decline in investments is so because investments are now more expensive.

Figure 1

Limitation of Fiscal Policy

  • Disincentives of tax cuts - increasing taxes to reduce aggregate demand may cause disincentives to work. In such cases, there could be a decline in productivity and aggregate supply;
  • Spill-over effects on public spending – declines in government spending in order to decrease inflationary pressure could adversely affect the supply and provision of public services such as public transport, health and security among others;
  • Time Lags – if the government plans to increase spending through expansionary fiscal policy, this can take a long time to become effective. This can have an unintended effect on the economy;
  • Budget deficit – if the economy is close full employment, expansionary fiscal policy can 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;
  • Crowding out – increased government spending to increased aggregate demand may lead to a rise in the rate of interest thereby making borrowing for investing more expensive. This will discourage investments by the private sector;
  • Monetarist critique – economists who subscribe to the monetary trend of thought, argue that the long run supply curve is inelastic and increases in government spending will lead to inflationary pressures.

IS/LM Model

The IS-LM model, which stands for "investment-savings, liquidity-money," is a Keynesian macroeconomic model that shows how the market for economic goods (IS) interacts with the market for loanable funds (LM), or money market, and it is represented as a graph in which the IS and LM curve intersect to show the short-run equilibrium between interest rates and output. The three critical exogenous variables in the IS-LM model are liquidity, investment and consumption. According to the theory, liquidity is determined by the size and velocity of the money supply. The levels of investing and consumption are determined by the marginal decisions of individual actors. The IS-LM graph examines the relationship between real output, or GDP, and nominal interest rates. The entire economy is summarized as two markets, output and money, and their respective supply and demand characteristics push the economy towards an equilibrium point such as at Y1 where IS1 and LM1 interesct.

Figure 2

The IS curve tells you all combinations of Y and r that equilibrate the output market, given that firms are willing to supply any amount that’s demanded. That is, the IS curve is the set of all Y and r combinations that satisfy the output market equilibrium condition that total demand given income Y and the cost of borrowing r must equal total supply.

The LM curve tells you all combinations of Y and r that equilibrate the money market, given the economy’s nominal money supply M and price level P. That is, the LM curve is the set of all Y and r combinations that satisfy the money market equilibrium condition, real money demand must equal the given real money supply.

The point where the IS and LM schedules intersect represents a short-run equilibrium in the real output and monetary sectors. Both product and money markets are in equilibrium. This equilibrium yields a unique combination of interest rates and real GDP.

Next - The Role of Money