A fiscal policy is when the government changes taxation and increases government spending. Through an expansionary fiscal policy it aims at increasing the amount of disposable income people will have. This income will, depending on the marginal propensity to consume, be spent in the economy. The result of this will be that aggregate demand will increase thus eliminating the deflationary gap which is caused by either growth or unemployment. Moreover fiscal policy aims at increasing government spending. If government spending increases the investment in the economy which will be translated as an increase of investment in the economy and which will in turn close the deflationary gap. Through a contractionary demand side policy the government aims at decreasing the amount of disposable income and thus reducing consumption within the economy which will in turn lead in a reduction of aggregate demand. In terms of government spending the government will reduce government spending so as to reduce investment and t hus close the inflationary gap as illustrated by the following diagram.
As seen in the above diagram when an economy is faced with a deflationary gap its aim is to push the real consumption function leftward so as to close this gap which usually reflects either lack of growth or unemployment. In other words what this fiscal policy aims at is increasing consumption and thus in turn reducing unemployment and/or recession. On the other hand when the economy is faced with an inflationary gap it aims at shifting the real consumption function rightward so as to close that gap and thus eliminate inflation.
If however we examine the policies best fitted to increasing growth and combating unemployment, we will see that a fiscal policy is not always the best approach. In the case of equilibrium unemployment we see that there are several types of unemployment and thus several economic policies to combat them. In the case of frictional unemployment we see that the best policy to combat it is by reducing job dissatisfaction through increasing job information and by reducing unemployment benefits so people have a disincentive to remain unemployed. In the case of structural unemployment we could increase education so as to eliminate occupational immobility and improve transportation so as to eliminate geographic immobility. Finally in the case of seasonal unemployment the government could spread economic activities for a longer time period. Thus from the above we conclude that in the case of equilibrium unemployment there is no point in using a fiscal policy seeing that this type of employment doesn’t occur due to lack of demand.
In the case of disequilibrium unemployment the government could either reduce government intervention in the labor market or reduce the power of labor unions so as to make the labor market more flexible to wage changes. Thus we see again that a fiscal policy has no exact purpose here because an increase in demand can’t permanently secure that the economy will never fall in recession so that wages won’t have to fall.
In the case of the economy wishing to stimulate growth a fiscal policy could prove very effective seeing that it increases the two main elements of demand namely domestic consumption and investment thus will probably trigger development. However the government has to be very cautious in assuring that this rapid development won’t lead the country to inflation or non-sustainable development.
Also if the economy is trying to combat inflation and it tries to implement a demand side policy this may lead to a dramatic increase in unemployment which is what happened in the case of Spain when it was trying to enter the EU.
Thus we see that while a fiscal policy does affect aggregate demand and does close the deflationary or inflationary gap the government due to several problems may not be able to stop implementing the policy exactly at the point when the gap has closed. This may cause inflation or unemployment to surge which is one of the main problems of demand-side policies, thus one may ask why the government prefers fiscal demand-side policies to supply-side policies. The fact is that despite their problems demand-side policies work faster than supply-side policies because the improvement in the factors of production supply-side policies aim at takes time to be fulfilled. Thus since the government needs to work fast so as to avoid an economic crisis a fiscal policy may prove to be more effective than a supply-side policy.
Thus from the above we conclude that the purpose of a fiscal policy is to eliminate a deflationary or inflationary gap in the economy as fast as possible so as to prevent an economic crisis and through this to fine tune and control the economy.
Although a fiscal policy does achieve in helping the economy for a short period of time by affecting the elements of aggregate demand namely investment and consumption it does have several problems that hinder its effectiveness.
On the one hand as previously stated an expansionary fiscal policy by decreasing taxation and increasing government spending the fiscal policy will probably achieve in increasing aggregate demand. This will happen since the decrease in taxation will increase people’s disposable income and consequently depending on the marginal propensity to consume the domestic consumption of an economy which in turn will increase aggregate demand. Similarly the government by increasing spending in all sectors of its economy it will increase investment which in turn may lead to an increase in aggregate demand. This is an effective way to combat economic problems such as unemployment and recession. On the other hand if a government wants to eliminate recession it will have to pursue a contractionary demand side policy. This policy will increase taxation thus decreasing the citizen’s disposable income thus in turn reducing consumption which will reduce aggregate demand which will in turn reduce inflation. On the other hand it will decrease government spending thus decreasing investment which will again reduce aggregate demand and thus in turn reduce inflation.
However these policies aren’t always very effective for several reasons. Firstly fiscal policy can’t be effective if consumption isn’t effective to tax changes in other words if there is a high marginal propensity to consume. What this will mean is that no matter how high the government raises taxes the people will still insist on spending as much as they previously did thus not decreasing domestic consumption. On the other hand if there is low marginal propensity to consume no matter how low the government drops the tax domestic consumption wont increase and thus domestic consumption wont increase.
Moreover a fiscal policy could lead to the crowding out effect. This is divided in two categories, resources and financial crowding out. In the case of resources crowding out this indicates an increase in reward for the factors of production. This happens in the case of an expansionary fiscal policy government spending on public and merit goods as a result the government increases demand for specific factors of production. This increased demand will lead to increases in wages, rent and interest rates. In the case of financial crowding out increased government spending will lead in an increase in demand to borrow money so as to finance this spending. As a result there will be an increase in interest rates which in turn may discourage investment from private firms.
Another problem that may occur is that the government may over or under estimate the problem and thus impose a non effective fiscal policy since it will either increase demand too much or too little. This may occur due to information problems seeing that information is sometimes difficult to collect on the exact position of the economy at any moment and thus may make false estimations on the extent to which the policy should be dragged. There is also the issue of time seeing that in order for the fiscal policy to be constructed this may take some time and by then the situation will be altered thus the policy wont be as effective.
Finally there is the issue of the fiscal drag that may make fiscal policies ineffective. This happens because if the government keeps increasing government spending with taxation levels remaining stable the government may move into recession and a deflationary gap might emerge. This can be explained by the fact that people earning higher income due to an increase in government spending will move to a higher income bracket and pay higher taxation something that will reduce consumption on their part and leas the economy to slowdown instead of growth.
Thus from the above we see that fiscal policies are effective but in a very limited number of situations seeing that they often backfire.