Fiscal Policy Examples and Tools

Oftentimes, economists contrast fiscal policy with monetary policy which a country’s central bank enacts and not the elected government officials.

What is fiscal policy in economics?

Fiscal policy in economics is the use of government spending and policies with regard to tax to influence the state of an economy especially when it comes to macroeconomic conditions. This includes the aggregate demand for goods and services, employment, inflation, and economic growth. It has to do with the amount of money that comes into the country through taxes and the amount that goes out through spending such as defense, welfare, and education.

Fiscal policy is a highly politicized aspect of an economy because it is the government that has sole control over it. In essence, it encompasses the things that the government decides to spend its money on and the amount it wants to bring in from the taxpayer. For example, the government may be under pressure from the public to invest more funds in local schools. In this case, the government may either borrow money or increase taxes.

In case of recession, the government can adopt expansionary fiscal policy through the lowering of tax rates to increase aggregate demand which will help in fueling economic growth. On the other hand, the government can adopt a contractionary fiscal policy if the economy is facing increasing inflation and other expansionary symptoms.

Keynesian theory of fiscal policy

Largely, fiscal policy is on the basis of the idea of John Maynard Keynes. He argued that governments could stabilize the business cycle and regulate the output in an economy by making adjustments in spending and tax policies to fill in the gap that the private sector is unable to fill in. Keynes also argued that economic recessions come as a result of a deficiency in the consumer spending and business investment components of aggregate demand.

His theories came about in response to the Great Depression which challenged the assumptions of classical economics that economic swings were self-correcting. These ideas were influential and they amounted to the New Deal in the United States. This involved massive spending on public works projects and social welfare programs.

According to Keynesian economics, either spending or aggregate demand is the driving factor of economic performance and growth. Aggregate demand comprises business investment spending, consumer spending, net government spending, and net exports. Keynesian economists believe also that the components of aggregate demand in the private sector depend greatly on psychological and emotional factors to maintain economic growth.

Among consumers and businesses, fear, pessimism, and uncertainty can bring about economic recessions and depressions. On the other hand, in good times, excessive exuberance can bring about inflation and overheat in the economy. However, Keynesian economics suggests that governments can manage taxation and spending in a rational manner and also use it to counteract the deficiencies and excesses of private-sector consumption, and investment spending in order to bring about stability in the economy.

In a situation whereby private-sector spending turns down, the government can spend more and tax less in order to directly increase aggregate demand. In cases whereby the private sector is excessively optimistic and spends too much, too fast on consumption and new investment projects, the government can spend less or impose more tax in order to reduce aggregate demand.

This implies that the government has to run large budget deficits in cases of economic downturns and run a budget surplus in cases of economic growth to help stabilize the economy. These measures are expansionary and contractionary fiscal policies respectively.

Types of fiscal policy

There are two basic types of fiscal policies namely;

  • Expansionary fiscal policy
  • Contractionary fiscal policy

Expansionary fiscal policy

The government uses expansionary fiscal policy to kick-start the economy during a recession. It helps in boosting aggregate demand, which in turn, increases output and employment in the economy. When the government is in pursuit of expansionary fiscal policy, it increases spending, reduces taxes, or does the two. Because government spending is one of the components of aggregate demand, its increase will shift the demand curve to the right. When the government reduces taxes, there will be more disposable income and this will bring about an increase in consumption and savings thereby shifting the aggregate demand curve to the right.

An increase in government spending alongside a reduction in taxes will as well shift the aggregate demand curve to the right. The extent to which the aggregate demand curve shifts is dependent upon the size of the spending multiplier. This shift in the aggregate demand curve usually may result from either taxation or government spending. On the other hand, the shift in the aggregate demand curve in response to a reduction in tax is dependent upon the size of the tax multiplier. The expansionary policy will bring about a budget deficit if government spending is greater than tax revenues.

Contractionary fiscal policy

Government authorities implement a contractionary fiscal policy when there is demand-pull inflation in the economy. They can use this to pay off unwanted debt. In pursuit of contractionary fiscal policy, the government can decrease spending, raise taxes, or combine the two. Contractionary fiscal policy shifts the aggregate demand curve to the left. This type of policy brings about a budget surplus, that is if tax exceeds government spending. In essence, the government pursues a contractionary fiscal policy probably to the extent of inducing a brief recession in order to help in restoring a balance in the economic cycle.

Objectives of fiscal policy

The objectives of fiscal policy are as follows;

  • Full employment
  • Price stability
  • The acceleration of economic growth rate
  • Optimal resource allocation
  • Equitable income and wealth distribution
  • Economic stability
  • Capital formation and growth
  • Encouraging investment

Full employment

The primary objective of fiscal policy in developing economies is to achieve as well as maintain full employment in an economy. Even if such countries do not achieve full employment, their aim is to avoid unemployment and achieve an economic state that is close to full employment. So, in order to reduce unemployment or underemployment, it is necessary for the state to spend sufficiently on economic and social overhead. These expenditures will help the state to achieve more employment opportunities and increase the economy’s productive efficiency.

Looking at this, public expenditure and public sector investment have a significant role to play in a modern state. An investment that is properly planned will not just expand income, output, and employment. It will also increase effective demand through the use of the multiplier process and this will gear the economy towards full employment. Aside from public investment, the state can also encourage private investment through tax holidays, concessions, cheap loans, subsidies, etc.

In rural areas, the state can make attempts to encourage domestic industries by offering them training, cheap finance, equipment, and marketing facilities. When the government spends on all these measures, it will help in eradicating unemployment and underemployment.

Keynes, therefore, recommended the following ways of achieving full employment in an economy;

  • Capture the excessive purchasing power and curtail private spending
  • Use public investment to compensate the deficiency in private investment
  • Adopt a cheap money policy or lower interest rates in order to attract more private entrepreneurs.

Price stability

A general agreement exists that economic growth and stability are joint objectives for countries that are underdeveloped. In developing countries, economic instability manifests itself in the form of inflation. It is therefore certain that inflation is a permanent phenomenon in developing countries. This is because such economies are in a situation where there is a tendency of a rise in prices due to an expansion in the trend of public expenditure. As a result of an increase in income, demand exceeds supply. This in turn makes capital goods and consumer goods fail to increase in correspondence to the rise in income. In turn, this will bring about an inflationary gap.

The rise in price that comes about as a result of demand-pull which cost-push inflation further reinforces will bring about a further increase in the gap. The rise in the prices of commodities will bring about a rise in the demand for more wages. Furthermore, this will give rise to repetition in the wage-price spirals. If an economy fails to control this situation, it may turn into hyperinflation.

Therefore, it is important for fiscal policy to attempt to remove the bottlenecks and structural rigidities that bring about imbalances in various sectors of the economy. It should also be able to strengthen physical controls of essential commodities, granting concessions, subsidies, and protection in the economy. It is important to note that fiscal measures alongside monetary measures work hand in hand to achieve the objective of economic growth and stability.

The acceleration of economic growth rate

In a developing economy, fiscal policy should primarily aim at achieving an acceleration in economic growth. However, a country cannot achieve and maintain a high economic growth rate without economic stability. An economy should therefore use fiscal measures such as taxation, public borrowing, deficit financing, etc, properly. This is to avoid a situation whereby production, consumption, and distribution will be adversely affected.  Fiscal measures should promote the economy in its entirety which will help in raising national income as well as per capita income.

The more an economy grows, its citizens as a whole become more prosperous. Therefore, economic growth is an important objective for any country to achieve. simultaneously, governments must be careful because an aggressive expansionary fiscal policy can be dangerous in the long run. While aiming at economic growth, a country should also consider stability alongside. For example, heavy government spending can contribute to inflation and bring about high levels of debt. This in turn destroys the wealth of an economy.

Optimal resource allocation

Fiscal measures have a great impact on the allocation of resources in different occupations and sectors of the economy. In developing countries, national income is very low. To gear the economy towards growth, the government can push the growth of infrastructure through the adoption of fiscal measures. Measures like public expenditure, subsidies, and incentives will have a favorable influence on the allocation of resources in the desirable channels.

Also, tax exemptions and tax concessions have the tendency of helping to attract resources towards favorable industries. On the other hand, high taxation may push resources away in a specific sector. Above all, curtailing consumption and investments that are socially unproductive may be helpful in the mobilization of resources and further place checks and balances on the inflationary trends in the economy. In some cases, the policy of protection is a useful tool of growth for some industries that are socially desirable in a developing country.

In order to raise the saving ratio that provides finance required for developmental schemes, Prof. R.N. Tripathi suggests the following measures;

  • Direct physical control
  • Increase the existing tax rates
  • Introduce new taxes
  • Public borrowing that is non-inflationary in nature
  • Deficit financing

Equitable income and wealth distribution

It is certain that equitable distribution of income and wealth is significant to the growth of an economy. In general terms, wealth inequality persists in developing economies as in their early stages of growth. In this situation, wealth is concentrated in a few hands. This concentration of wealth in few hands comes as a result of the fact that private ownership is dominant in the entire economic structure. When these inequalities become extreme, they can bring about political and social discontentment which will furthermore destabilize the economy. Because of this, the government can devise a suitable fiscal policy to bridge the existing gap between the incomes of the various sections of society.

In order to reduce inequalities and be even in distribution, the government should invest in those channels that incur benefits to low-income groups. These channels are certainly helpful in raising their productivity and technology. Redistributive expenditure is meant to help economic development, as well as economic development, should help redistribution.

If an economy properly plans its fiscal program, public expenditure can help in the development of human capital. In turn, this possesses positive effects on the distribution of income. This can also help in removing regional disparities especially by providing incentives to backward regions. A redistributive tax policy would be highly progressive whereby a greater tax burden is on the rich than the poor. Poorer sections of the community can even be exempted from taxation. Similarly, items that are luxurious, which the higher section consumes can also be subject to heavy taxation. In turn, this will help in transferring wealth from the rich to the poor.

Economic stability

Another aim of fiscal measures is to foster economic stability in the face of short-run international cyclical fluctuations. In terms of trade, these fluctuations can bring about variations, making the most favorable to the developed and unfavorable to the developing economies. For the purpose of bringing about stability in the economy which is so important, fiscal measures should incorporate inbuilt flexibility in the budgetary system in order for the income and expenditure of the government to automatically provide a compensatory effect on the rise and fall of the national income.

Fiscal policy is an economic measure that plays a leading role in the maintenance of economic stability in the face of both internal and external forces. The policy known as tariff policy is a correcting measure for the external forces rather than an aggressive fiscal policy. In the face of an economic boom, the government should impose import and export duties in order to reduce the impact of international cyclical fluctuations.

Also, to curb the use of additional purchasing power, the government should impose heavy import duty on consumer goods as well as restrict imports. In the face of recession, the government can incorporate public works programs through deficit financing.

Capital formation and growth

It is obvious that capital assumes a central position in a country’s development program. In this case, fiscal policy is a crucial tool for promoting the highest rate possible of capital formation. A developing country usually possesses a virtuous cycle of poverty. In this case, such countries need balanced growth to overcome the virtuous cycle. This is only feasible when the rate of capital formation is higher.

  • To attain rapid economic growth, Prof. Raja J. Chelliah recommends that fiscal policy should aim at;
  • A rise in the ratio of savings (S) to income (Y) by controlling consumption (C).
  • Raising the rate of investment
  • Encourage the flow of spending into productive channels
  • A reduction in the glaring income and wealth inequalities

With this, it is critical for the government to design a fiscal policy to take place in two ways; that is by expanding investment in public and private sectors and then diverting resources from entities that are socially less desirable to those that are more desirable.

To encourage investment

Fiscal policy is relevant in accelerating the rate of investment in both the public and private sectors of an economy. It should help in encouraging investment in the public sector which in turn will bring about an increase in the volume of investment in the private sector. This implies that fiscal policy should aim at economic growth and development and must encourage investment in those channels or entities that are more desirable from the societal point of view.

Also, fiscal measures should aim at curtailing conspicuous consumption and investment in channels that are unproductive. In the early stage of economic development, the government should put efforts in building social overheads such as transport, communication, irrigation schemes, flood controls, ports, health facilities, etc. in order to induce investment from external economies especially in the industrial and agricultural sectors of the economy.

These economies will help to widen the size of the market thereby reducing the cost of production and bringing about an increase in the social marginal productivity of investment.

Fiscal policy tools

The government authority has two major tools they can use when deciding fiscal policy. Although they are kind of interlinked, they do not completely depend on each other. These tools are;

  • Taxation
  • Government spending

Taxation

Governments make use of taxation as a way of funding expenditure. Although taxes tend not to be popular with voters, they generally desire greater spending on education, healthcare, and defense. Because of this, a tough balancing act exists that most governments fail to follow. They spend more frequently than they receive taxes. Taxation as a tool comes in different forms such as corporate tax, income tax, sales tax, etc.

The general motive behind the government using tax as a fiscal tool is to fund expenditure. However, they use it to stimulate the economy particularly in the face of recession. Governments can achieve this by reducing the level of taxation. By implication, if there is more money in private hands, it can boost consumer confidence and spending. In other words, consumers spend more money in the economy.

However, when there is more money in private hands, it implies less government spending. Well, it is far cheaper to reduce taxes in the face of recession than in the face of an economic boom. This is because of the fact that there are fewer obs which implies lower income and tax receipts and lower corporate profits which also implies lower corporate tax receipts. In essence, the opportunity cost is lower.

Generally, taxes have effects on the average consumer’s income which in turn brings about changes in the average consumer consumption. When consumption changes, there will be a corresponding change in the real GDP of a country. In essence, if the government adjusts taxes, it can have an influence on economic output. The government can change taxes in several ways. One is to either raise or lower marginal taxes. The government can entirely eliminate taxes or modify the tax rules as well.

Government spending

Another type of fiscal policy that is important in shaping an economy is government spending. One of the things the government spends on is social security which tends to take the largest part of the expenses. The manner in which the government spends is very important.

The general aim of government spending is to play a key role in the economy such as defense, law, and order, reduce social inequality through redistribution, gain public support, and facilitate economic growth. In essence, the growth of an economy is dependent upon how the government spends its funds.

How does fiscal policy affect economic growth?

Taxation

As earlier stated, fiscal policy is the decisions or policy of the government with regard to taxation and spending. The economy tends to grow when the government reduces taxes. This is because a decrease in tax will bring about an increase in the disposable income of individuals. This, in turn, brings about an increase in demand which will require companies to produce more. Furthermore, the company will need to hire more employees thereby giving people more money to either save or spend.

Also, if the government perceives that the economy is overheating, it can decide to raise taxes thereby causing people to have less money to spend. In turn, this will require companies to hire fewer people, bringing about a decrease in demand. When people are unemployed, they will certainly have less purchasing power. They will not have extra money to spend, save, or invest. So the economic growth will slow down.

Government spending

For the government to stimulate economic growth, it will increase its expenditure on goods and services thereby increasing the demand for goods and services. Production goes up proportionately with the increase in demand. Also, the increase in production will bring about more employment as the need for companies to hire more people will arise. In turn, the unemployed who now have jobs will have more money to spend on goods and services. Furthermore, the demand for goods and services will still increase as well as require more production. This is how the cycle of growth will continue. Consequently, government spending tends to increase economic growth.

On the other hand, if the government perceives that the economic growth is too fast or overheating, it can reduce its spending. In turn, a decrease in government spending will bring about a decrease in the aggregate demand in the economy. This will have an effect on companies as they will reduce production thereby bringing about a decline in their profits. Also, some workers will have to be laid off thereby reducing the amount of money in people’s pockets to spend. The demand for goods will decrease thereby decreasing the production of goods. By implication, the cycle will repeat itself.

There is usually a concern in the hearts of economists that an increase in government spending and tax reduction will bring about a crowding-out effect. This is because if the government does not have sufficient funds/revenue to support its expenditure, then it will have to borrow money. Some economists believe that the more the government borrows, the more the increase in interest rates. An increase in interest rates will discourage individuals and companies from borrowing money for spending and investment. These economists, therefore, believe that government spending is bound to crowd out private investment.

The impact of fiscal policy on an economy’s GDP

The fiscal policy has an impact on a country’s GDP through the multiplier. The multiplier is the ratio of change in national income to the change in government spending that causes it. The multiplier effect then comes about when an initial incremental amount of spending brings about an increase in income and consumption. Furthermore, there will be an increase in consumption as income increases which brings about an overall increase in the GDP of a country.

Economists have used the multiplier effect to argue in favor of the efficacy of government spending or tax relief in order to stimulate aggregate demand. The rate of an increase in a country’s GDP is dependent upon the type of fiscal policy the government adopts.

Usually, the multiplier on the changes in government spending is greater than the multiplier on the changes in the levels of taxation. It is so because of the fact that the part of any change that occurs in taxes is absorbed by savings

For example, in the form of tax cuts, the government hands out $50 billion. Government purchases of goods and services will have no direct effect on aggregate demand. The GDP will rather go up because households spend part of that $50 billion. In this case, households will spend; Marginal propensity to consume multiplied by $50 billion (MPC*$50billion). If MPC = 0.6, the initial increase in consumer spending will be $30 billion. Now, because of the initial increase in consumer spending, there will be subsequent rounds whereby the GDP, consumer spending, and disposable income will further rise. This is how the cycle continues.

Simply put, the government hands out $50 billion in the form of tax cuts, to calculate the consumer spending if the MPC is 0.6. will be 0.6*$50 billion = $30 billion

Marginal propensity to consume (MPC) comes about when we divide the change in income (Y) by the change in consumption, thus;

MPC = ΔY/ΔY

In cases whereby an economy is facing a recession, it is not necessary for government spending to make up for the entire output gap. A multiplier effect exists that will help in boosting the impact of government spending. The government can increase its expenditure in a modest manner to stimulate a lot of new products if the recipients of this money consume most of it. This extra spending provides more room for companies to hire more workers and pay them. In turn, this will bring about a further increase in spending and this occurs continuously in a virtuous cycle.

Aside from changes in government spending, the government can close recessionary gaps by reducing income taxes. This in turn will bring about an increase in the aggregate demand and real GDP. In response to this, prices will increase. On the other hand, if the government wants to close the expansionary gap when the economy is overheating, it would increase income taxes which in turn will bring about a decrease in aggregate demand, GDP, and prices.

It can limit or crowd out the effects of fiscal policy. Crowding out takes place when government spending simply replaces the output of the private sector rather than adding to the output of the economy. It also takes place when government spending brings about an increase in interest rates thereby limiting investments.

Expansionary fiscal policy can bring about an increase in an economy’s real GDP that is greater than the initial rise in aggregate spending which the policy causes. On the other hand, contractionary fiscal policy can bring about a fall in the real GDP of an economy greater than the initial decrease in the aggregate spending which the policy causes.

Therefore, the multiplier effect is the determinant of the extent to which fiscal policy shifts the aggregate demand curve as well as has an impact on output.

The relevance of the fiscal multiplier

The multiplier is relevant because it measures the impact of a fiscal stimulus on the gross domestic product (GDP) of an economy. Fiscal stimulus refers to the increase in government spending in order to stimulate the growth of an economy. The fiscal multiplier is not the same as a monetary multiplier. The monetary multiplier has to do with the impact of changes in money supply on economic output. The central bank is the driver of the fiscal multiplier as it controls the supply of money using the interest rates. On the other hand, government spending drives the fiscal multiplier, usually tangible things like building infrastructure and other social programs.

Multiplier formulas

The two basic types of fiscal multipliers are;

  • The expenditure multiplier
  • Revenue multiplier

Expenditure multiplier

The expenditure multiplier measures the change in output for every amount that the government spends. Below is the formula for calculating the expenditure multiplier.

Expenditure multiplier = ΔY/ΔG

where,

ΔY = Change in output
ΔG = Change in government spending

Revenue multiplier

The revenue multiplier measures the change in output for every increase in the amount of revenue that the government collects. Below is the formula for calculating revenue multiplier;

Revenue Multiplier = ΔY/ΔT

where,

ΔY = Change in output
ΔT = Change in government revenue or taxes

Measuring the multiplier

It is extremely difficult to estimate the fiscal multiplier because of the complexity of the economy. Also, multiple forces exist in an economy that affects its output. This brings about a situation whereby it becomes too difficult to point out the changes in output that one can directly attribute to fiscal policy.

The approaches to estimating the fiscal multiplier are;

  • Econometric or statistical approach
  • Simulation or model-based approach
  • Bucket approach

Econometric approach

Economists perform the econometric approach of estimating multiplier through the use of a statistical model known as a structural vector autoregressive model (SVAR). This is a multivariate time series model that makes analyses of the relationship between multiple variables over time. This approach requires a lot of data which is usually unavailable. Although this approach is on the basis of data, the results tend not to be stable.

Simulation approach

The simulation or model-based approach creates a model of the economy and then makes use of simulation to bring out an estimate of the required variable. Under this approach, economists use the Dynamic Stochastic General Equilibrium (DSGE) models to model the economy. They use this to model the different sectors that exist in an economy as well as the interactions that take place between them. Although the simulation approach does not require a lot of data, it suffers from model risk.

 Bucket approach

The bucket approach is the method that estimates the fiscal multiplier which is dependent on the way an economy ranks on different factors. It provides a figure for the multiplier on the basis of the experiences of other economies that possess similar features.

Factors affecting the multiplier

There are many factors that determine the size of a multiplier. Generally, the fiscal multiplier is higher when government control over the economy increases. These factors are in two categories namely;

  • Structural factors
  • Conjunctural factors

Structural factors

Structural factors have to do with the permanent features of the economy. The responses to fiscal stimulus vary across economies. The structural factors include;

  • Debt level
  • Trade openness
  • Exchange rate regime
Debt level

When the debt levels are high, it can bring about a reduction in the impact of the fiscal multiplier. This is because an economy uses any physical stimulus to service debt before using them for activities that are more productive. This causes the output to increase by a smaller amount. This implies a reduction in the fiscal multiplier.

Trade openness

There is an inverse relationship between the fiscal multiplier and trade openness. the physical stimulus becomes more effective when there are high restrictions on trade. This is because in this case, the output is not dependent upon the global economy. When an economy is highly dependent upon an external economy, it will not be able to productively absorb the fiscal stimulus if the global economy remains weak.

Exchange rate regime

The more flexible an interest rate regime is, the smaller the multiplier becomes. This is a result of the fact that a reduction in the value of the currency can offset any growth push that fiscal stimulus. This also implies a decrease in the purchasing power in an economy.

Conjunctural factors

These are passing or transitory features of the economy that can have an effect on the size of the multiplier. The conjunctural factors are;

  • Business cycle
  • Monetary policy
Business cycle

When the economy is in a downturn, the multiplier tends to be larger. On the other hand, the multiplier tends to be smaller. This is because, during expansion, the economy has little capacity to absorb government spending and any fiscal stimulus crowds out private consumption. This causes the multiplier to remain low.

Monetary policy

A monetary policy that is accommodative can bring about a great increase in the fiscal multiplier. This comes about when interest rates are low which makes the fiscal stimulus to be higher. A lower cost of capital serves as a growth catalyst in the output. In this case, an output can grow even with a small amount of fiscal stimulus.

Fiscal stimulus simply refers to the actions the government takes to influence economic activities.

Importance of fiscal policy

The economy will certainly not always work smoothly as the levels of economic activities will always fluctuate. The economy will either find itself in recession or an economic boom. During recessions, there is a lot of underutilization of productive capacity. This means that machines and factories are working below their capacity. This brings about an increase in the unemployment of labor alongside the existence of excess capital stock.

when an economy is overheating, this implies inflation where the prices of goods and services persistently rise. Because of this, a lot of economic instability exists in the free market or capitalist economy. The classical economists believe that automatic stabilizers or mechanisms will restore economic stability, that is, the recession will flush out itself and there will be an automatic control of inflation. However, there is empirical evidence during the 1930s when there was a severe depression in the Western capitalist economies that there are no such things as the automatic stabilizers/mechanisms that work to bring about economic stability. Another evidence is in the second world war, therefore, there is nothing like the automatic stabilizers.

For this reason, Keynes argued that the government has to intervene in an economy to curb inflation, recessions, and depression by employing the tools of the macroeconomic policy, fiscal and monetary policies. Keynes believed that monetary policy is not effective in bringing the economy out of depression. He emphasized the role fiscal policy plays in stabilizing the economy. However, modern economists believe that both fiscal and monetary policies play a crucial role in bringing about stability in the economy.

As explained above, fiscal policy is important in facilitating economic and price stability, capital formation, and investment. If the economic growth is slow, the government can decide to reduce taxes or increase spending, or both. On the other hand, in the face of economic overheating, the government can decide to increase taxes or reduce government spending, or both.

What are some examples of fiscal policy?

An instance is when the government spends money on the construction of a plant. This spending becomes wages to builders and in turn, the builders will have more disposable income. This increases their consumption and aggregate demand. Furthermore, this can bring about an increase in the construction of other plants where more builders will be hired for the construction work. The cycle then continues. However, if the economy begins to overheat, the government can reduce its spending or increase taxation.

Fiscal vs monetary policy

Both fiscal and monetary policies are two major tools that influence the economic activities of a country. However, they differ in the following ways;

Fiscal policy has to do with how the government manages the economy’s aspect of spending and taxation. The government uses fiscal policy to stabilize the economy as well as help in the growth of the economy. On the other hand, the central bank manages and forms monetary policies which have to do with the regulation of money supply and interest rates of the economy. In essence, while the government manages fiscal policies, the central bank manages monetary policies.

While fiscal policy has to do with the management of tax revenues and policies with regard to government spending to benefit the economy, monetary policy has to do with the regulation of the flow of money and interest rates in an economy.

The Ministry of Finance of an economy is in charge of managing fiscal policy while for the monetary policy, it is the Central bank of an economy. The fiscal policy measures the taxes and capital expenditure of an economy while the monetary policy measures interest rates with regard to lending money in an economy. While fiscal policy focuses more on the growth of an economy, monetary policy focuses more on the stability of an economy.

The monetary policy has no impact on exchange rates between currencies, that is the local currency and another country’s currency. On the other hand, the monetary policy has an impact on exchange rates between currencies. As interest rates go higher, exchange rates improve. Although the fiscal policy has objectives, it does not have a specific target. On the other hand, monetary policy targets inflation in an economy. While fiscal policy has an impact on the budget deficit of an economy, monetary policy has an impact on the borrowing that takes place in an economy.

FAQs on Fiscal Policy

What are the three fiscal policies?

Although there are two major types of fiscal policies which are expansionary and fiscal policies, a third one is the neutral fiscal policy.

Expansionary
This is a fiscal policy that the government employs during a recession in order to kick-start the economy. It helps in boosting aggregate demand, which in turn, increases output and employment in the economy. When the government is in pursuit of expansionary fiscal policy, it increases spending, reduces taxes, or does the two. In essence, this fiscal measure is meant to increase economic activities.

Contractionary
Contractionary fiscal policy that in which the government adopts when there is demand-pull inflation in the economy. They also use this policy to pay off unwanted debt.

Neutral
Governments usually undertake neutral fiscal measures when an economy is at equilibrium. The government, in this case, fully funds its expenditure using the revenues it generated from taxes. This will have a neutral effect on the level of economic activities in the country.

What are the three fiscal policies?

Although there are two major types of fiscal policies which are expansionary and fiscal policies, a third one is the neutral fiscal policy.

Expansionary

This is a fiscal policy that the government employs during a recession in order to kick-start the economy. It helps in boosting aggregate demand, which in turn, increases output and employment in the economy. When the government is in pursuit of expansionary fiscal policy, it increases spending, reduces taxes, or does the two. In essence, this fiscal measure is meant to increase economic activities.

Contractionary

Contractionary fiscal policy that in which the government adopts when there is demand-pull inflation in the economy. They also use this policy to pay off unwanted debt.

Neutral

Governments usually undertake neutral fiscal measures when an economy is at equilibrium. The government, in this case, fully funds its expenditure using the revenues it generated from taxes. This will have a neutral effect on the level of economic activities in the country.

How can fiscal policy affect investments?

Fiscal policy can have both direct and indirect effects on one’s investments. For instance, the government can increase or decrease tax rates which will leave one with more or less disposable income to invest. In this case, one may have to adjust his investment strategy. Fiscal policy can have an impact on the overall economy as earlier pointed out. It also has an impact on the interest rates, certain industries, and significant companies.

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