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Economics - Essay Example

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Fiscal policy may be defined as that part of government policy which through determining federal taxation and government spending and thereby influencing the effective demand aims to smoothen the effects of the business cycles in the short run and attain full employment,…
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Economics

Download file to see previous pages... In this case, the government may increase spending or reduce taxes or simultaneously adopt both measures to raise the aggregate effective demand. In this case, the government faces a budget deficit. Adopting an expansionary fiscal policy facing a situation of depressed economic activities reflected in lowered aggregate output levels and rising unemployment is the Keynesian prescription. Such policies are considered by governments during economic downturns.
Contractionary Fiscal policy refers to a situation of raised taxes or lowered government spending or both in pursuit of curtailing the aggregate demand. Generally such policies are adopted to counter an inflationary situation fuelled by rising demand. Adoption of contractionary fiscal policies is considered during the upturns of the business cycles.
An expansionary fiscal policy is illustrated in the diagram below using a standard IS-LM framework. As government spending rises with or without reduced taxes, the aggregate effective demand rises for all rates of interest and thus assuming sufficient unused productive capacities this implies a decline in unsold stocks leading to increased output for all rates of interest thereby leading to a rightward shift in the IS curve. As a result, the aggregate real output rises (Y1 to Y2) and so does the real rate of interest. The rise in rate of interest is caused by a rise in the government borrowings. However this rise in interest rates dampens the private inducements to invest. This is known as a crowding out effect as in essence private investments are crowded out by raised government borrowings (Mankiw, 2002).
Thus, we see that while an expansionary fiscal policy may be successful in increasing the real aggregate national income and generating employment, it also leads to a decline in private investments which in turn reduce the effective demand. Thus, in the process of increasing borrowings to fund the excess spending or reducing taxes, ...Download file to see next pagesRead More
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