Fiscal Policy Instruments - Essay Example

? Fiscal Policy Fiscal Policy Discuss what is meant by fiscal policy. What are the instruments of fiscal policy? Fiscal policy refers to the means used by the government in spending and taxation to monitor or influence the economy (Abdih et al. 2010). In a way, the government has to adjust its level of spending to influence the economy. This fiscal instrument is used by the government each year to manage its economy for the benefit of the citizens. The tax implications on the nation’s budget have different inferences to different groups of people within society. Fiscal policy focuses generally on the fiscal changes in government revenue and expenditure and their impact upon nation’s economy. Tax and expenditure are the basic fiscal policy instruments. However, the most potent fiscal instrument used by a government is taxation. Taxation has led to reduction of consumption, increases investments, and allow for the transfer of government resources to economic development. Taxation has impact to the general level of output by altering the incentives that institutions encounter. Taxation is imposed by government to cut the cost of governance and communal services (Talvi & Vegh 2000). Taxation also facilitates resource re-allocation, and enhances the promotion through equitable wealth distribution, to enhance economic growth and development. This also ensures economic stability by correcting and controlling macroeconomic shocks which are both policy-induced or exogenous. Hence, we are able to understand the gap between the level of expenditure and taxation. When the government revenue is high, the liquidity trap increases in the money supply, which does not contribute to the improvement of economic growth due to downward pressure experienced in investment (because of insensitivity of interest rate compared to money supply) (Alesina & Tabellini 2005). Likewise, this may also occur when the government expenditure surpasses revenue. The most important factor to consider in such a case is not the level of the deficit but the change that accompanies the deficit. Fiscal policy is an important instrument that is used to monitor government’s economy due to its impact on GDP (Alesina & Tabellini 2005). Fiscal policy has been associated with the use of taxation and public expenditure to influence the level of economic activities. The implementation of fiscal policy is channeled through government’s budget.  An important aspect of a public budget is its use as a tool in the management of a nation’s economy (Alesina & Tabellini 2005). During economic recession, the government plans for budget deficit which is often referred to as expansionary fiscal policy. In such a situation, taxes are reduced with a subsequent increase in the government expenditure, and during depression, or economic boom, the government may decide on a budget surplus to slow down the economy. This implies that through reduction in taxes, the purchasing power of individuals is enhanced and the cost of production of workers reduces, thereby improving their scale of operations in the business cycle. On the other hand, increases in public expenditure when effectively used can lead into improved developments in the nation’s infrastructure. Consequently, there is an increase in general welfare and places the economy on the path of growth. This explains the first impact of fiscal policy on improving the demands for goods and services. The aggregate demands make it an important instrument for a government’s economic stabilization. Fiscal growth has affects the output level and has implications on a country’s savings. Thus, in fiscal expansion, the government will be forced to reduce savings, which is equivalent to a budget surplus. The reduction in fiscal deficits may lead to increase in domestic production. Furthermore, it may lead to stable exchange rate that should be pursued as means of controlling inflation in a nation. 2. With the aid of a diagram, show and explain how fiscal policy can be used to shift the aggregate demand. Evaluate the effectiveness of the policy used. Aggregate demand is a term used to refer to the sum total of expenditures of individuals, investments, governments, foreigners, as well as goods and services that are produced domestically (Alesina & Tabellini 2005). Thus, consumer behavior of final goods and services in the aggregate are indicated by the aggregate demand curve (AD). Aggregate demand curve indicates the total produced goods and services. It is represented by the real output (y), since the buying power of consumers varies at different inflation rates. Having other things constant, the level at which the price level changes (inflation rate) and the buying power of people becomes inverse. When prices of goods and services increase at a faster rate, individuals’ purchasing power decreases hence the amount of goods and services people are willing to buy reduces drastically (Alesina & Tabellini 2005). This is referred to as the wealth effect. This can be plotted in a curve that slopes downwards. The demand curve will shift with changes in the total spending of the domestic goods and services as indicated in the diagram below. Figure I Demand Curve vs. Spending (Source: Aggregate Demand 2009) As illustrated in the above diagram, there are changes in the total spending of people on domestically produced goods and services. The factors that make the aggregate demand curve to shift to the right include: a) increases in the following: household consumption, investment, government spending, exports and foreign purchases, household wealth (that eventually bolsters consumption levels), and money supply; and b) reduction in the following: imports and the purchases of foreign goods and services by local residents, taxes that increases consumption, and business or investment spending. Consequently, the factors that lead to reduction in aggregate demand and shift the aggregate demand curve to the left includes: a) a decrease in the following: household consumption or spending, investment, government expenditure, foreign purchases or exports, household wealth, and money supply; and b) increase in the following: imports and taxes. Generally, the factors listed involve decreases in consumption and investment spending (Ilzetzki & Carlos 2008). Fiscal policy has implications on the aggregate demand for goods and services. Fiscal policy has implications on the output level in the long run since it affects the country’s savings rate. Therefore, a fiscal expansion leads to a reduction in government savings. In a situation where there is lower savings, the government will have to increase its borrowings abroad. Low investment will also lead into a reduced capital stock and a reduction in the country’s ability for future investment. If the government reduces taxes and makes increments on the transfer payments, or disposable household income increases, there will be an increase in expenditure on consumption. The rise in consumption consequently increases the aggregate demands. This is one of the effects of fiscal policy in increasing aggregate demands. Furthermore, fiscal policy also affects the composition of the aggregate demand, especially when the government runs a deficit and meets some obligations by issuing bonds. With all factors made constant, fiscal expansion increases the interest rates. The impact of fiscal policy in increasing aggregate demand happens only when prices are inflated but there is no effect on the output. 3. Access the 2010-11 Australian Government’s Budget papers and with the aid of statistics, explain the fiscal policy stance adopted. According to the Australian government budget papers, it is evident that the natural calamities that rocked Australia and the poor outlook in revenue had serious implications on the fiscal policy outlook for 2010-11 and 2011-2012. However, these challenges have changed because of the government’s commitments to have a strong fiscal policy in place. The Australian government is making tremendous efforts to improve its physical infrastructures to improve the livelihood of the people. However, the economy will be affected because of the losses incurred in 2010-11 and 2011-12. Natural disasters affected government revenue because of the negative impacts on production that led to loses. The government focuses to return the budget surplus in 2012-13. This means that the government will work towards strengthening its resources to support businesses that will ensure that the economy stabilizes. The fiscal consolidation is intended to increase the government’s capacity to monitor economic growth and respond to future anticipated natural disasters. There is a focus to increase the budget surplus in three years, when after the global financial crisis, the fastest fiscal consolidation has occurred (Australian Government 2011). The government has made some recommendations for improvements in fiscal strategies on its expenditures that also cover the cost of the recent natural calamities. The savings have been cut and which amount is channeled to reduction payments. The effect of this upon fiscal policy is an increase in government spending that averages 1 percent annually for a five-year period since 1980’s. The country’s net debts are expected to increase to a maximum of 7.2 percent of the GDP in 2011-12. This rate is higher, and indicates the implications of natural calamities and reduced government revenues. However, the Australian balance sheet is one of the strongest in the developing world. Compared to most developed economies, the Australian net debt in 2011-12 is much less, estimated at 0.1 percent. 4. What are the current inflationary pressures being experienced in the Australian economy. Evaluate the appropriateness of the government’s fiscal policy stance. Globally, there exists a gap between production and the demand of goods and services which has contributed to a drastic decline in commodity prices. For instance, in Australia, it is projected that the terms of trade might decline from the recent highs recorded in the previous years. This had negative impact to Australian economy which is estimated at a cost of $35 billion in 2009-10. As a result, the country expects little investment because of a reduction in domestic and global demand of goods and services (Australian Government 2011). Households are also affected since they experience lower wealth and their buying power is also reduced. The weakening of the global economy and the global recession led to a fall of inflation in Australia. However, Australia will stand a chance to withstand the current inflationary pressures compared with other economies because it is projected that the former’s economy will stabilize. The Australian government fiscal policy and reduced interest rates are predicted to moderate the effect of global recession on domestic economy. Furthermore, the downturn has no detrimental impact to the financial systems which nations can avoid or will not feel. In Australia, the employment rates are projected to increase by approximately 175 percent in the year 2012-13 and will sustain in the proceeding years. In addition, inflation is expected to moderate over the same period. But due to the fragility in the global economy, the inflation rate may decline further, causing negative impacts on the Australian economy. References Abdih Y, Lopez-Murphy P, Roitman A, & Sahay R 2010. The Cyclicality of Fiscal Policy in the Middle East and Central Asia: Is the Current Crisis Different?, IMF Working Papers WP/10/68. Aggregate Demand, 2009. http://tutor2u.net/economics/content/topics/ad_as/ad-as_notes.htm [Accessed 12 September 2011]. Alesina A & Tabellini G 2005. Why is Fiscal Policy Often Procyclical?, NBER Working Papers No 11600. Australian Government, Budget Strategy and Outlook, Budget Paper No.1. http://www.bournemouth.ac.uk/library/citing_references/docs/Citing_Refs.pdf [Accessed 12 September 2011]. Ilzetzki E & Carlos AV 2008. Procyclical Fiscal Policy in Developing Countries: Truth or Fiction?, NBER Working Papers 14191. Talvi E & Vegh CA 2000. Tax Base Variability and Procyclical Fiscal Policies, NBER Working Papers No. W7499. Read More