A Detailed Study on Fiscal Policy

In this article, we will discuss the meaning, objectives and importance of fiscal policy. You must have heard about this term even if you have a basic knowledge of economics. This is because the government uses fiscal policy to regulate the economic activity in the country. The policy can be used to accelerate the economy when the country is facing a major economic downfall and also be used to slow down the economy when there is huge inflation. I know you have a lot of questions. Don’t worry, keep reading this article to find answers to all your questions.

What is Fiscal Policy and Why Does it Matter?

British economist John Maynard Keynes has founded the concept of fiscal policy which states that government spending and tax policies have a direct impact on the economy of the country. Basically, the policy helps the government in finding answers to these two important questions: how much money they should spend and how much revenue they should earn in the form of taxes to balance the economic cycle. Fiscal policy has a direct impact on the following:

• Aggregate demand for goods and services
• Employment
• Inflation

According to Keynesian economics, aggregate demand or how much consumers are spending is the key factor that impacts the performance and growth of the economy. Aggregate demand consists of following  components:

1. Consumer spending
2. Business investment spending
3. Net government spending
4. Net exports

How does Fiscal Policy Work?

Fiscal policy works with two major tools: taxes and spending. Let’s assume that the economy is working very slow. This indicates that the consumers are not spending money to buy products. Now, try to understand why people are not demanding products. Yes, your answer is correct, people don’t have enough money to buy products. To increase the money in the hands of the people, the government will cut down the taxes. Individuals will have more money to buy various products and services. This increasing demand will in turn increase employment opportunities. 

In the end, all these things will ultimately have a positive impact on the economy. On the other hand, if the people are spending too much the government will increase the taxes which will indeed reduce the demand of the people and the economy will come back on track. The key thing is to find the right balance and make sure that the economy is at the centre. 

Objectives of Fiscal Policy:

• Ensures growth of the economy
• Maintains price stability and controls inflation
• Aims for full or near employment
• Optimum allocation of resources

Types of Fiscal Policy:

There are two types of fiscal policy. They are as follows:

Expansionary Fiscal Policy:

Expansionary fiscal policy is used at times of recession or when unemployment is very high. The primary objective of this policy is to boost aggregate demand. Government injects more money into the economy so that the purchasing power of the people rises and they increase the aggregate demand. During this policy, the government cuts down the tax rates or spends its revenue on infrastructure improvements. Although like any other policy this one needs to be implemented with accurate calculations. Otherwise too much in the economy can lead to high inflation or an overheated economy. 

Contractionary Fiscal Policy:

Contractionary fiscal policy is the complete opposite of the expansionary fiscal policy. This policy is implemented when the inflation rate in the country is very high. During this policy tax and interest rates are increased. Due to this people have less money to spend and ultimately the aggregate demand gradually decreases.

How Fiscal Policy Affects Businesses:

During the expansionary fiscal policy, the investment opportunities for the businesses increase because a lot of money is flowing into the economy and tax rates are also very low. The growth rate of the business increases when a balance between price and demand is met. On the other hand, the contractionary fiscal policy slows the growth rate of the business due to rising taxes and the decreasing aggregate demand. Fiscal policy also aims to decrease the unemployment rate. When the aggregate demand increases business owners need more people for management and for other business activities. Thus, the employment opportunities increase.

Conclusion:

As you can see, fiscal policy has a significant impact on how the economy performs. If used correctly it can help the government balance the economic flow and boost the growth rate. Just remember that the fiscal policy is influenced by the taxes and how much money people are spending. The policy guides the government on how much money to spend and how much revenue to earn in the form of taxes.