Fiscal Policy

We often associate fiscal policy with Keynesian economics, a concept developed by John Maynard Keynes to understand the Great DepressionKeynes argued for increased government spending and lower taxation in an attempt to recover the economy as soon as possible in the short run. Keynesian economics believes that an increase in aggregate demand can boost economic output and take the country out of a recession.

Fiscal Policy Fiscal Policy

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    In the long run we are all dead. - John Maynard Keynes

    Fiscal policy is a type of macroeconomic policy that aims to achieve economic objectives through fiscal instruments. Fiscal policy uses government spending, taxation, and the government’s budgetary position to influence aggregate demand (AD) and aggregate supply (AS).

    As a reminder of the basics of macroeconomics, check out our explanations on Aggregate Demand and Aggregate Supply.

    What are the features of fiscal policy?

    Fiscal policy has two important features: automatic stabilisers and discretionary policy.

    Automatic stabilisers

    Automatic stabilisers are fiscal instruments that respond to the upturns and downturns of the economic cycle. These processes are automatic: they do not require any further policy implementation.

    Recessions tend to lead to higher unemployment rates and lower income. During these times, people pay fewer taxes (due to their lower income) and rely more on social protection services like unemployment benefits and welfare. As a result, government tax revenues decrease, while public expenditure increases. This automatic increase in government spending, accompanied by lower taxation, helps curb the drastic decrease in aggregate demand. During a recession, automatic stabilisers help reduce the effects of a fall in economic growth.

    On the contrary, during an economic boom, automatic stabilisers help reduce the economy’s growth rate. When the economy is growing, income and employment levels rise as people work more and paying more in taxes. Therefore, the government receives higher tax revenues. This, in turn, leads to a drop in expenditure on unemployment and welfare benefits. As a result, tax revenues increase faster than income, restraining the increase in aggregate demand.

    Discretionary policy

    Discretionary policy uses fiscal policy to manage the levels of aggregate demand. To increase aggregate demand, the government would purposefully run a budget deficit. However, aggregate demand levels become too high at one point, increasing the price level through demand-pull inflation. This would also increase imports into the country, leading to a balance of payments problem. As a result, the government is forced to use deflationary fiscal policy to reduce aggregate demand.

    Keynesian economists, therefore, used a discrete form of fiscal policy to optimise the level of aggregate demand. They regularly changed taxation and government spending to stabilise the economic cycle, achieve economic growth and full employment, and avoid high inflation.

    What are the objectives of fiscal policy?

    Fiscal policy can take one of two forms:

    • Reflationary fiscal policy.

    • Deflationary fiscal policy.

    Reflationary or expansionary fiscal policy

    Demand-side fiscal policy can be expansionary or reflationary, which aims to increase aggregate demand (AD) by increasing government spending and/or decreasing taxes.

    This policy aims to increase consumption by lowering tax rates, as consumers now have a higher disposable income. Expansionary fiscal policy is used to close recessionary gaps and tends to increase the budget deficit as the government borrows more to spend more.

    Remember AD = C + I + G + (X - M).

    The policy results in the AD curve shifting to the right and the economy moving to a new equilibrium (from point A to point B) as national output (Y1 to Y2) and price level (P1 to P2) increase. You can see this in Figure 1 below.

    Expansionary Fiscal Policy StudySmarter OriginalsFigure 1. Expansionary Fiscal Policy, StudySmarter Originals

    Deflationary or contractionary fiscal policy

    Demand-side fiscal policy can also be contractionary or deflationary. This aims to decrease aggregate demand in the economy by decreasing government spending and/or increasing taxes.

    This policy aims to decrease the budget deficit and discourage consumption, as consumers now have lower disposable income. Governments use contractionary policy to decrease AD and close inflationary gaps.

    The policy results in the AD curve shifting to the left and the economy moving to a new equilibrium (from point A to point B) as national output (Y1 to Y2) and price level (P1 to P2) decrease. You can see this in Figure 2 below.

    Contractionary Fiscal Policy StudySmarter OriginalsFigure 2. Contractionary Fiscal Policy, StudySmarter Originals

    Government budget and fiscal policy

    To further understand fiscal policy, we first need to take a look at the budgetary positions a government can take (where G stands for government spending and T for taxation):

    1. G = T The budget is balanced, so government expenditure is equal to revenues from taxation.
    2. G> T The government is running a budget deficit, as government expenditure is higher than tax revenues.
    3. G <T The government is running a budget surplus, as government expenditure is lower than tax revenues.

    Structural and cyclical budget position

    The structural budget position is the economy’s long-term fiscal position. It includes the budgetary position throughout the entirety of the economic cycle.

    The cyclical budget position is the economy’s short-term fiscal position. The economy’s current position in the economic cycle, like a boom or a recession, defines it.

    Structural budget deficit and surplus

    As the structural deficit is not related to the current state of the economy, it doesn’t get resolved when the economy recovers. A structural deficit is not automatically followed by a surplus, as this type of deficit changes the structure of the entire economy.

    A structural deficit suggests that even after considering cyclical fluctuations in the economy, government spending is still being financed by borrowing. Moreover, it indicates that government borrowing will soon become less sustainable and increasingly more expensive due to increased debt interest payments.

    An increasing structural deficit implies the government will have to impose stricter policies to improve finances in the public sector and balance its budgetary position. These may include a significant increase in taxation and/or a decrease in public expenditure.

    Cyclical budget deficit and surplus

    Cyclical deficits occur during a recession in the economic cycle. This is often followed by a cyclical budget surplus when the economy recovers.

    If the economy is experiencing a recession, tax revenues will decrease and public expenditure on unemployment benefits and other forms of social protection will increase. In this case, government borrowing will increase and the cyclical deficit will also increase.

    When the economy is experiencing a boom, tax revenues are relatively high and expenditure on unemployment benefits is low. The cyclical deficit, therefore, decreases during a boom.

    As a result, the cyclical budget deficit eventually gets balanced out by a budget surplus when the economy is recovering and experiencing a boom.

    What are the consequences of a budget deficit or surplus in fiscal policy?

    The consequences of a budget deficit include increased public sector debt, debt interest payments, and interest rates.

    If the government is running a budget deficit, it implies an increase in public sector debt, meaning that the government will have to borrow more to finance its activities. As the government runs a deficit and borrows more money, the interest on borrowings rises.

    A budget deficit can also lead to an increase in aggregate demand due to increased public expenditure and lower taxation, which results in higher price levels. This can signal inflation.

    On the other hand, budget surplus can result from sustained economic growth. However, if a government is forced to increase taxation and decrease public expenditure, it might result in low economic growth, due to its effects on aggregate demand.

    A budget surplus can also lead to higher household debt if consumers are forced to borrow (due to high taxation) and pay off their debt, resulting in low spending levels in the economy.

    The multiplier effect occurs when an initial injection passes through the circular flow of income of the economy several times, creating a smaller and smaller additional effect with each pass, thereby ‘multiplying’ the initial input effect on the economic output. The multiplier effect can be positive (in the case of an injection) and negative (in the case of a withdrawal.)

    How are monetary and fiscal policy related?

    Let’s take a look at how fiscal and monetary policy are correlated.

    Recently, the UK government has used monetary policy, rather than fiscal policy, to influence and manage the levels of aggregate demand to stabilise inflation, boost economic growth, and decrease unemployment.

    On the other hand, it uses fiscal policy to gain macroeconomic stability by overseeing public finances (tax revenue and government spending,) and stabilising the government’s budgetary position. The government also uses it for achieving supply-side objectives by creating incentives for people to work more and for businesses and entrepreneurs to invest and take more risks.

    Fiscal Policy - Key takeaways

    • Fiscal policy is a type of macroeconomic policy that aims to achieve economic objectives through fiscal instruments.
    • Fiscal policy uses government spending, taxation, and the government’s budgetary position to influence aggregate demand and aggregate supply.
    • Discretionary policy uses fiscal policy to manage the levels of aggregate demand.
    • Governments use discretionary policy to avoid demand-pull inflation and a balance of payments crisis.
    • Demand-side fiscal policy can be expansionary, or reflationary, which aims to increase aggregate demand by increasing government spending and/or decreasing taxes.
    • Demand-side fiscal policy can also be contractionary or deflationary. This aims to decrease aggregate demand in the economy by decreasing government spending and/or increasing taxes.
    • The government budget has three positions: balanced, deficit, surplus.
    • Cyclical deficits occur during a recession in the economic cycle. This is most often followed by a subsequent cyclical budget surplus when the economy recovers.
    • The structural deficit is not related to the current state of the economy, this part of the budget deficit does not get resolved when the economy recovers.
    • The consequences of a budget deficit include increased public sector debt, debt interest payments, and interest rates.
    • The consequences of a budget surplus include higher taxation and lower public expenditure.
    Frequently Asked Questions about Fiscal Policy

    What is fiscal policy?

    Fiscal policy is a type of macroeconomic policy that aims to achieve economic objectives through fiscal instruments. Fiscal policy uses government spending, taxation policies, and the government’s budgetary position to influence aggregate demand (AD) and aggregate supply (AS).

    What is expansionary fiscal policy?

    Demand-side fiscal policy can be expansionary, or reflationary, which aims to increase aggregate demand (AD) by increasing government spending and/or decreasing taxes.

    What is contractionary fiscal policy?

    Demand-side fiscal policy can be contractionary or deflationary. This aims to decrease aggregate demand in the economy by decreasing government spending and/or increasing taxes.

    How does fiscal policy affect interest rates?

    During an expansionary or reflationary period, interest rates are likely to increase due to the additional government borrowing that is used to finance public expenditure. If the government borrows more money, interest rates are likely to increase as they have to attract new investors to lend money by offering higher interest payments.

    How does fiscal policy affect unemployment?

    During an expansionary period, unemployment is likely to decrease due to the increased levels of aggregate demand and economic growth experienced by the economy. 

    Test your knowledge with multiple choice flashcards

    Taxation should be:

    Which of the following is not a direct tax?

    Fiscal policy attempts to influence aggregate demand through:

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