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February 16 2009 | Filed Under Bonds , Economics , Retirement
Fiscal policy is the means by which a government adjusts its levels of spending
in order to monitor and influence a nation's economy. It is the sister strategy
to monetary policy with which a central bank influences a nation's money
supply. These two policies are used in various combinations in an effort to
direct a country's economic goals. Here we take a look at how fiscal policy
works, how it must be monitored and how its implementation may affect different
people in an economy. (For background on fiscal policies, see Formulating
Monetary Policy.),
Before the Great Depression in the United States, the government's approach to
the economy was laissez faire. But following the Second World War, it was
determined that the government had to take a proactive role in the economy to
regulate unemployment, business cycles, inflation and the cost of money. By
using a mixture of both monetary and fiscal policies (depending on the
political orientations and the philosophies of those in power at a particular
time, one policy may dominate over another), governments are able to control
economic phenomena.
How Fiscal Policy Works
Fiscal policy is based on the theories of British economist John Maynard
Keynes. Also known as Keynesian economics, this theory basically states that
governments can influence macroeconomic productivity levels by increasing or
decreasing tax levels and public spending. This influence, in turn, curbs
inflation (generally considered to be healthy when at a level between 2-3%),
increases employment and maintains a healthy value of money. (To read more on
this subject, see Can Keynesian Economics Reduce Boom-Bust Cycles? and How
Influential Economists Changed Our History.)
Balancing Act
The idea, however, is to find a balance in exercising these influences. For
example, stimulating a stagnant economy runs the risk of rising inflation. This
is because an increase in the supply of money followed by an increase in
consumer demand can result in a decrease in the value of money - meaning that
it will take more money to buy something that has not changed in value.
Let's say that an economy has slowed down. Unemployment levels are up, consumer
spending is down and businesses are not making any money. A government thus
decides to fuel the economy's engine by decreasing taxation, giving consumers
more spending money while increasing government spending in the form of buying
services from the market (such as building roads or schools). By paying for
such services, the government creates jobs and wages that are in turn pumped
into the economy. Pumping money into the economy is also known as "pump
priming". In the meantime, overall unemployment levels will fall. (To learn
more about inflation and employement, see Surveying The Employment Report and
The Importance Of Inflation And GDP.)
With more money in the economy and less taxes to pay, consumer demand for goods
and services increases. This in turn rekindles businesses and turns the cycle
around from stagnant to active.
If, however, there are no reins on this process, the increase in economic
productivity can cross over a very fine line and lead to too much money in the
market. This excess in supply decreases the value of money, while pushing up
prices (because of the increase in demand for consumer products). Hence,
inflation occurs.
For this reason, fine tuning the economy through fiscal policy alone can be a
difficult, if not improbable, means to reach economic goals. If not closely
monitored, the line between an economy that is productive and one that is
infected by inflation can be easily blurred. (For more on economic cycles, see
Understanding Cycles - The Key To Market Timing and How Much Influence Does The
Fed Have?)
And When The Economy Needs To Be Curbed
When inflation is too strong, the economy may need a slow down. In such a
situation, a government can use fiscal policy to increase taxes in order to
suck money out of the economy. Fiscal policy could also dictate a decrease in
government spending and thereby decrease the money in circulation. Of course,
the possible negative effects of such a policy in the long run could be a
sluggish economy and high unemployment levels. Nonetheless, the process
continues as the government uses its fiscal policy to fine tune spending and
taxation levels, with the goal of evening out the business cycles.
Who Does Fiscal Policy Affect?
Unfortunately, the effects of any fiscal policy are not the same on everyone.
Depending on the political orientations and goals of the policymakers, a tax
cut could affect only the middle class, which is typically the largest economic
group. In times of economic decline and rising taxation, it is this same group
that may have to pay more taxes than the wealthier upper class.
Similarly, when a government decides to adjust its spending, its policy may
affect only a specific group of people. A decision to build a new bridge, for
example, will give work and more income to hundreds of construction workers. A
decision to spend money on building a new space shuttle, on the other hand,
benefits only a small, specialized pool of experts, which would not do much to
increase aggregate employment levels.
Conclusion
One of the biggest obstacles facing policymakers is deciding how much
involvement the government should have in the economy. Indeed, there have been
various degrees of interference by the government over the years. But for the
most part, it is accepted that a degree of government involvement is necessary
to sustain a vibrant economy, on which the economic well being of the
population depends.
(For the latest on U.S. and global economic conditions, try the Economic
Section at Forbes.com.)
by Reem Heakal