The macroeconomic policy is usually seen as having two components namely the fiscal policy and the monetary policy. Fiscal policy portrays the process of government funding, and the activities that are funded, including compiling a government budget.
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In order to uphold fiscal policy, the population as well as the individuals who purchase government debt instruments need to see it as predictable and capable of continuing with its debt payments. When government revenue sources are able to accommodate its expenses in terms of government programs, then the fiscal policy is observed to be prudent.
The rationality of a fiscal policy is also observed when the government informs the population of its budget and the concept behind coming up with that kind of a budget, which is a regular process due to the auditing of government financial statements. The association between fiscal policy and monetary policy is that a nation’s currency would lose its value if its fiscal policy was observed to be unsustainable (Barro and Redlick 2009).
According to Keynesian economists, unemployment can be easily managed by governments using fiscal policy, in that it can increase the demand in the economy. Employment is observed to be a product of the demand created in the economy due to private economic activity. When this does not create adequate opportunities, fiscal policy can increase the demand by stimulating economic activity, leading to increases employment opportunities.
According to Keynes, fiscal policy is a strategy used to involve the government in dynamic organization of the economy. Keynes observed the need for the government to take an active role due to the prolonged cases of unemployment during the Great Depression. This respected economist came up with the idea that the government should create job opportunities without having to rely on the private sector (Keynes 2010).
An active fiscal policy helps to stimulate an upward cycle of economic activity. This is made possible by the government’s use of taxing and spending policy. Ideally, the private sector invests in productive assets in order to maximize its output, which leads to a higher demand for labour, therefore creating employment.
The stimulus generated from active fiscal policy is referred to as fiscal stimulus. Through fiscal stimulus, the government spends more, which results in higher income for private individuals. As a result, these individuals spend more through consumption, which increases the demand for commodities.
Higher demand for commodities implies the need for increased supply, which is possible by the increased company output. In order for companies to increase their output, they need to hire more people, who then begin spending based on their income. This generates a cycle, due to increased demand for commodities imposed by the new spenders, which translate to more output, and more labourers. This is the upward cycle of economic activity, referred to as demand management (Ilzetzki 2010).
Fiscal stimulus is made possible through deficit spending. This is because the government expenditure is higher than its revenue. Government fiscal policies are based on the methods used by governments to formulate fiscal stimulus based on deficit spending, which creates government programs. According to Ilzetzki, there are several methods of creating deficit spending (Ilzetzki, Mendoza and Végh 2010).
“Increased government spending with taxes remaining unchanged, reduced taxes with unchanged government spending, and the combination of reduced taxes and increased government spending.”
The first instance of deficit spending was observed in 1938, when the federal government budget increased by about 6% from the previous year (Ilzetzki, Mendoza and Végh 2010).
The fiscal stimulus is meant to produce a temporary improvement in economic activity that leads to commencement of the upward cycle. Deficit spending is observed to work in theory but not practically. The fiscal stimulus has been observed to increase government spending, which in turn creates employment, but the spending does not decrease once its purpose is attained.
This is because the extra spending by the government is used to start programs for particular groups, and the government cannot withdraw from such programs, or reduce its funding. Economists have observed that the private sector is in a better place to create long term productivity.
This is because unlike the government, the private sector operates on a profit incentive. Deficit spending is observed to be increase the government debt, and this demands the resources in the community to be redirected from the private sector in order to pay the debt (Fatás and Mihov 2001).
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The ‘Golden Rule’ of fiscal policy was adopted by the Labour Party when Gordon Brown was Chancellor. This rule states that:
“The government should borrow to invest only for future needs, over the full economic cycle. The tax revenues should be used to meet current needs in order to allow for stable finances as defined by ratios of public sector net worth, debt and current expenditure to national income (Ilzetzki 2010).”
At the same time, the UK government intended to abide to the sustainable investment rule. This was aimed at maintaining the national debt at a rational level. In the year 2008 the public debt had risen from 40$ to 42% of GDP, and was expected to increase to 70% by 2010.
The coordination between the UK monetary and fiscal policy was examined for the presence of any issues, resulting from the formation of the Office for Budget Responsibility (OBR). Creation of the OBR was advantageous in that it increased the confidence levels of the economic forecasts on which fiscal policy was based by not being affected by political expediency (Ilzetzki 2010).
The possible effects of fiscal policy on the economy were the increased debt and deficits due to long-term interest rates, requiring consolidation for growth based on lower long-term interest rates and decreased demand due to contraction.
A contraction was expected to cause depreciation in exchange rates, and an increase in external demand, but this effect would be decreased by the simultaneous reduction in demand by trading partners of the UK. Optimal design of the fiscal policy demanded that the taxes be stable to reduce costs on the private sector.
It was also necessary that the government corrects the shocks to debt, in order to contain its magnitude. The other factor influencing the optimal fiscal policy was the worry that he lack of action in reducing government debt would lead to reduced private investment. The policy also found it prudent to share the risk in various generations, whereby the effects of a war or crisis would not be imposed on a single generation (Barro and Redlick 2009).
The Mundell-Flemming model illustrates an increase in exchange rates due to fiscal stimulus, in nations where the exchange rates are flexible.
This is seen to balance the effect of the fiscal stimulus, as it leads to reduced exports and more imports. In order for the central banks to ensure stable exchange rates, they decrease the interest rates as a result of increased government consumption after a fiscal stimulus.
Central banks aimed at increasing inflation tend to raise the interest rates in order to oppose the stress caused by inflation due to fiscal expansion. This counteracts the stimulative effect of fiscal policy, hence nullifying the fiscal stimulus. The effects of fiscal stimulus are dependent on the association between fiscal policy and monetary policy.
The response of the Bank of England in evaluating the possible outcomes of the economy resulting from the stern measures implemented by the UK government is an example of this. The response of the bank would take an approach that is similar to that of most central banks if it contains the economic costs using loose monetary policy, though it is unlikely to react in such a manner due to the banks rates and unusual programme of purchase of assets (Barro and Redlick 2009).
Delays have been observed in the implementation of public policy, in demand management using fiscal policy. The fiscal stimulus is most effectively implemented when the economy is performing poorly. From studies conducted on the processes of deficit spending, increased economic growth and employment has been followed by decreased economic growth and unemployment. This is because it is not easy to predict the best time to implement a fiscal stimulus, which is at the exact moment of the economic downturn.
This is because the government requires time to compile a budget proposal that suggests the stimulus. The budget then has to be approved by the legislative body. The government then needs to spend, and wait for the effect to raise the demand, according to the economic cycle. These lags in public policy are problematic for the effective management of the economy, by the government, using fiscal policy (Fatás and Mihov 2001).
It is possible for the government and the private sector to compete for the scarce economic resources simultaneously, when the government spends on one of its programs while the private sector increases its economic resources.
This makes the fiscal stimulus spending counterproductive, and capable of making the situation worse, due to the usage of the scarce resources during the crisis. The budget cycles of all governments use fiscal policy, though its use as demand management raises issues that result in debate in economics (Fatás and Mihov 2001).
Barro, Robert, J and Charles, J. Redlick, 2009. “Macroeconomic e¤ects from government purchases and taxes.” NBER Working Papers No. 15369.
Fatás, Antonio and Ilian Mihov, 2001. “The effects of fiscal policy on consumption and employment: Theory and evidence.” CEPR Discussion Papers 2760.
Ilzetzki, Ethan, 2010. Does Fiscal Policy Work? London: CentrePiece Autumn.
Ilzetzki, Ethan, Enrique G. Mendoza and Carlos A. Végh, 2010. “How Big (Small?) are Fiscal Multipliers?” NBER Working Paper No. 16479, pp 1-23.
Keynes, John Maynard, 2010. The General Theory of Employment, Interest and Money, 1936. Whitefish, MT: Kessinger Publishing.