Fiscal Policies as the Best Way of Achieving the Macroeconomic Objectives of an Economy - Literature review Example

Fiscal policies are the best way of achieving the macroeconomic objectives of an economy Fiscal policies are the best way of achieving the macroeconomic objectives of an economy Fiscal policies can be defined as the government program of making discretionary modification in the pattern and level of its taxation, borrowing and expenditure with the aim of achieving certain economic goals including income equality, increasing employment, stabilization of the economy and economic growth. Government can use its statutory powers to change the composition and magnitude of its inflows and outflows and hence change the magnitude of macroeconomic variables that include private savings, investments and the aggregate consumption expenditure (Dwivedi, 2010:601). Fiscal policy consists of the fiscal instruments and the target variables. Fiscal instruments are the tools used by the government to attain a particular economic goal. They include government spending, taxation, public borrowing and deficit financing. The target variables include aggregate consumption, savings, investments, imports, exports, disposable income and the structure and level of prices (Dwivedi, 2010:602). Taxation policy- the government collects funds from the public in forms of taxes. The taxes can either be direct or indirect. Taxes affect either the prices of good or the income of the people. By adjusting the taxes, the government will be able to meet its economic goals (Jain, 2007:393). Government expenditure- the government spending or expenditure includes purchases of goods and services like cars. It can raise or lower the GDP. The government can adjust its expenditure in order to achieve a particular economic goal. Public expenditure can either be: public expenditure incurred in the purchase of services and goods or public expenditure incurred without purchase of good or services that is, transfer payments that include scholarships, transfer payments, pensions and medical facilities among others (Jain, 2007:393). Deficit financing- this refers to the measures by the government to finance a deficit budget mostly by borrowing from its central bank. It results to increase the peoples income, and it hence increases the aggregate demand (Jain, 2007:393). To achieve the macroeconomic objective other measures have been adopted that guide the government in its economic activities. Fiscal rules have been set up that include the golden rule and public debt rule and are adopted in the U.K. In the U.K. the golden rule was adopted in 1998. It stipulates that the government should only borrow in order to invest and not to fund current spending. It requires the current budget either to be in balance or surplus but not in deficit; this is aimed at protecting investment spending. This rule ensures that the country does not cut on its public investment in order to improve government borrowing. Lowering of public investment results reduces potential output growth and is hence harmful (Honjo, 2007:3). The U.K government manages a sustainable investment policy which requires the public sector net debt to be held at a stable and prudent level. The net debt is the proportion of the GDP. According to this rule, the net debt should be maintained at a rate lower than 40% of the GDP. These rules have enabled the government to reduce its rates of borrowing, and the economy has achieved tremendous growth (Menifield, 2011:191). The government uses the fiscal policy tools to achieve macroeconomic objectives. The fiscal policies are either expansionary or contractionary. Expansionary fiscal policies are implemented when the fiscal balance is in a deficit, that is, spending is higher than revenue. At this period the economy is in a recession characterized by deflation, high unemployment and negative growth rate. The system is used to pump more money into the economy and include increased government spending, increasing transfer payments and reduction of taxes. These systems increase the aggregate demand, increases output, employment and income. It also increases the levels of prices and consequently leads to inflation. The policies hence enable the government meet its objective of increasing employment, economic growth and reduce deflation (Pailwar, 2010:158). Diagram is showing effect of expansionary fiscal policy The government reduces taxes and increases borrowing, this results to an increase in the disposable income which results to an increase in aggregate demand and the AD curve is hence pushed upwards, to the left. The real GDP also increases as shown in the diagram above. In a boom, the economy experiences high-inflation rates and high-output growth. The fiscal balance is in a surplus meaning revenue levels are higher than spending. In this case, the government adopts measures to withdraw money form the economy. Such measures include; increasing the tax rates and lowering its expenditure. Higher taxes result to an increase in the prices of goods hence forcing the households to pay more for the goods, and this reduces the disposable income. Reduced government spending also reduces the disposable income to the government suppliers. Therefore, these measures will be a decrease in inflation, employment rates and output (Pailwar, 2010:158). Diagram is showing the effect of contractionary fiscal policy The government needs to contract the expanding market; it hence increases taxes and also reduces its expenditure. This reduces the purchasing power of its citizens; as a result, of the reduced disposable income. The aggregate demand, therefore, decreases and also results to a decrease in aggregate demand. Despite its effectiveness, fiscal policy faces significant challenges. These challenges includ;e increase of taxes to reduce aggregate demand which may act as a disincentive to work. Also reduced government spending with the aim of reducing aggregate demand may affect essential public services as health and transport. In addition, poor information may result to the application of the wrong policy and this may have dire consequences and government spending is inefficient in most cases since higher government spending aimed at expanding the economy may be wasted in insufficient projects and hence fail to achieve the desired objective. As discussed depending on whether the economy is in a boom or recession, the government adopts relevant expansionary or contractionary fiscal policies. These are also known as discretionary fiscal policies since they are adopted during the crisis with the aim of correcting it. The government can adopt a discretionary change in the form of the expansionary or contractionary policies, or it can adopt a discretionary restrictive policy where it discontinues an existing program. These programs are not in-built, and they take time before they are implemented. To curb the challenge of the time lag other in-built measures are put in place, they are also known as the automatic stabilizers. These systems immediately respond to a crisis without the influence of the government or any other body. They exist prior to the boom and recession and mainly focus on managing the countrys aggregate demand. A good example of the automatic stabilization is the unemployment benefit to citizens. In a period of recession the level of unemployment increases resulting to an increase by the government on unemployment benefits schemes, increased government expenditure results to an increase in aggregate demand and hence in the long run there is increased income, and the defect is corrected. The same happens for the growth period and hence no decisions on changing the levels of taxes, or expenditure is made but the economy corrects crisis with no interference from the government or other bodies (Pailwar, 2010:161). In conclusion, despite the challenges facing the fiscal policy it is a useful tool which if well implemented would a since a government achieve its macroeconomic objectives. Governments should therefore adopt this tool but ensure they are well informed to order to be successful in their implementation. They should also consider other impacts that the tool will have in the economy and hence ensure effective implementation. In conclusion, Fiscal policies are therefore the best way of achieving the macroeconomic objectives of an economy. References Dwivedi, N. (2010) Macroeconomics: Theory and practice, 3rd edn. New Delhi: Tata McGraw Hill. Honjo, K. (2007) The Golden Rule and the Economic Cycles, IMF Working Paper, [online], Available: http://books.google.co.ke/books?id=YlPMVvD4B3IC&pg=PA3&dq=golden+rule+in+the+uk&hl=en&sa=X&ei=jA_PU6bXPOLl4QT6xYC4BA&redir_esc=y#v=onepage&q=golden%20rule%20in%20the%20uk&f=falseJain, T. (2007) Macroeconomics, New Delhi: V.K. Publications. Menifield, C. (2011) Comparative Public Budgeting: A global Perspective, Ontario: Jones & Bartlett Learning. Pailwar, V. (2010) Economic Environment of business, 2nd Ed. New Delhi: PHI Learning Private Limited. Read More