The Importance of Fiscal Policy
Expert reviewed • 14 August 2024 • 9 minute read
What is Fiscal Policy?
Fiscal policy is one of the two main policy tools used by governments to influence and stabilise their country's economy. It involves the strategic use of government spending and taxation to achieve economic objectives such as promoting growth, managing inflation, and reducing unemployment.
The two primary instruments of fiscal policy are:
- Government Spending: This includes all government expenditures on goods and services, infrastructure projects, public services (such as education and healthcare), and social welfare programmes. Increased government spending can stimulate economic activity by creating jobs and increasing demand.
- Taxation: Taxes are the primary source of government revenue. By adjusting tax rates and tax policies, the government can influence the level of disposable income available to consumers and businesses, thereby affecting overall economic activity.
What are the Types of Fiscal Policy?
There are two main types of fiscal policy:
- Expansionary Fiscal Policy: This involves increasing government spending and/or reducing taxes to stimulate economic growth. It is typically used during periods of recession or economic downturns. For example, the stimulus packages implemented by many countries during the COVID-19 pandemic are examples of expansionary fiscal policy. An example of this is in the recent Australian economy. The graph below displays this trend and how expansionary policy helps decrease unemployment levels.
- Contractionary Fiscal Policy: This involves decreasing government spending and/or increasing taxes to cool down an overheated economy. It is used to control inflation. For instance, if an economy is growing too quickly and causing high inflation, the government might implement contractionary policies to stabilise prices.
What are the Objectives of Fiscal Policy?
The main objectives of fiscal policy are:
- Economic Growth: By managing spending and taxation, the government aims to maintain a steady and sustainable growth rate. For instance, during a recession, the government may increase spending or cut taxes to boost economic activity.
- Price Stability: Controlling inflation is another critical goal. Excessive inflation can erode purchasing power, while deflation can lead to reduced consumer spending and economic stagnation.
- Full Employment: Fiscal policy can be used to reduce unemployment. For example, during periods of high unemployment, the government may increase spending on public projects to create jobs.
- Equitable Distribution of Income: Through progressive taxation and social welfare programmes, fiscal policy can help reduce income inequality.
The Mechanics of Fiscal Policy
To understand how fiscal policy works, we need to examine its impact on aggregate demand (AD) and aggregate supply (AS).
The Impact on Aggregate Demand
Fiscal policy primarily works through its effect on aggregate demand. Let's visualise this with a graph:
In this graph, we can see the initial equilibrium at the intersection of (E). When the government implements expansionary fiscal policy (e.g., increasing spending or reducing taxes), it shifts the aggregate demand curve to the right (E1). This results in:
- An increase in real GDP (economic growth)
- A rise in the price level (inflation)
The Impact on Aggregate Supply
While fiscal policy primarily affects aggregate demand, certain fiscal measures can also impact aggregate supply:
- Supply-side policies: Tax cuts or incentives for businesses can encourage investment and innovation, potentially shifting the AS curve to the right.
- Infrastructure spending: Government investment in infrastructure can improve productivity and shift the AS curve to the right in the long run.
What are the Strengths and Weaknesses of Fiscal Policy?
While fiscal policy can be a powerful tool for economic management, it has both strengths and limitations:
Strengths:
- Direct impact on aggregate demand
- Can be targeted to specific sectors or demographics
- Effective in combating severe economic downturns
Limitations:
- Time lags: There can be significant delays between policy implementation and economic impact.
- Political constraints: Fiscal policy decisions are often influenced by political considerations.
- Crowding out effect: Increased government borrowing can lead to higher interest rates, potentially reducing private investment.