Fiscal policy and regulation - Term Paper Example

Outline Topic Page No. ………………………………..………………………….………2 Fiscal policy………………………………………………...……………….3 Contractionary...............................................................................................6 Expansionary………………………………………...……………………..7 Effects……………………………………………………...………………...8 Use………………………………………………………………...…………8 Proponents of fiscal policy…………………………………..……………...9 Reasons of policy failure………………………………….………………..10 Abstract Fiscal policy is a government tool used to help control the economic trends or what is referred to as the economic cycle. Many may not understand how it works or how it is employed to help achieve economic stability. The Fiscal policy has its own weaknesses and may not work as expected; this is due to flaws such as timing which will also be examined in the essay. Lastly, the essay makes use of extensive scholars’ work gathered from various books as well as institutional books dealing with fiscal policy. Fiscal policy is the use of government funds through spending and taxation to achieve the required influences on the status of the economy. The scope of Fiscal policy is wide and involves several government functions all of which are aimed at ensuring spending is contained and restricted to those areas cum sectors where they have the greatest and positive effect on the economy. (Creel et al pp.8) The main entities for the fiscal policy are government revenues, government expenditures and debt management. Fiscal policy is usually as a result of a well thought process mainly involving the best economic minds that a country may have who are organized as Public Service Program or Capital Improvements Program. This paper will examine the various aspects of Fiscal Policy and its use by the government to achieve its various economic milestones. (Weil pp.1) Besides these, we will look at the main proponents of the Fiscal policy and the main reasons that fail the working of the policy. At the end of this essay, the reader should be able to understand fully the workings of the Fiscal policy and its various aspects. In the end, one maybe able to give an indication of why Fiscal policy may not work as intended. It is important though to note that though the impact of economic changes are felt by certain groups in the economy such as family units especially when the government offers tax cuts, the disposable income of this family increases. (Mont pp.75) The fiscal policy is not aimed at an examination of such mild changes or impacts but is focused on the effects of changes in the government budget as a whole. Fiscal policy Fiscal policy is usually looked one sided but a study of it reveals two types of fiscal policies which are not necessarily founded on different bases but are as a result of budget movement. These budget movements on the other hand are determined by the finances available to the government for the purpose of meeting its budgetary requirements. (Creel et al pp.32). These are either budget deficits or budgetary surplus or at very rare cases budgetary balance. Surplus budget- This is where the government revenue exceeds the government spending illustrated. Government revenue (T) > Government spending (G) Balanced budget-This is when the government revenue balances with the government expenditure. Government revenue (T) = Government Spending (G) Deficit budget- This is when government revenue falls short of meeting its expenditure level. Government revenue (T) < Government spending (G). An understanding of these three concepts can be achieved by looking at the United States Federal budget for the years 1962-2003. The graph below though has several factors alienated to represent specifically the budget positions in terms of deficits, surplus and balance. These include the alienation of business cycle conditions such as recessions; the graph has also been standardized to absorb inflation in cases where the same was on. This helps present a controlled budget which only illustrates the subject elements. Graph: Standardized and cyclically adjusted budget as a percentage of the Gross Domestic Product for the years 1962-2003. Source: Congressional Budget office through; http://www.econlib.org/library/Enc/FiscalPolicy.html A look at the above graph shows the budgets movement with the negative values denoting a deficit and the positive values illustrating a surplus. This graph goes into illustrating the presence of budget fluctuations which result to either expansionary policy or contractionary policy. The fiscal policy is said to be contractionary when the governments funds (T) are higher than its spending; earlier on discussed as a surplus situation. Expansionary policy is when the government spending is more than the available funds; a situation earlier referred to as a deficit situation. The most focused on effect of fiscal policies is the immediate effect of the policy which is to drive up the aggregate demand. (Weil pp.1)A fiscal expansion for example will increase the aggregate demand through two ways. The first is increasing the government spending and holding taxes at the same level as was before the change in spending (constant). The second way is to reduce the taxes levied on various goods and services, or increased payments; this will have an effect of increasing the disposable income available to individuals who as a result spend more for consumption purposes. Increases in demand for consumption goods will in turn lead to a rise in aggregate demand. Fiscal policy is also used by governments to alter the components of aggregate demand. When a government experiences distress as a result of minimal funds available to meet its obligations, it turns to other avenues which result to borrowing. (Mont pp.88). This is mainly by issuing bonds and other borrowing instruments. This creates an additional competitor in the market for private investors who are in search of money kept by savers. Citrus paribus the interest rates will shoot up and obviously force some private investments out of he market. The effect of this is that the fraction of private investments participating in this economy is reduced altering the composition of aggregate demand. Contractionary Contractionary policy is mainly as a result of two factors; one is either decreasing the total government spending which means a cut on purchases or increasing the tax. The policy is used when there is need to achieve a lower spending level when there is eminent inflation. (Creel et al 24). This is achieved through the following ways: By the government cutting on its expenditure: this is achieved by minimizing investments by the government, making fewer government related purchases and generally reducing government spending. Increasing taxes: increasing taxes reduces the disposable level available to households for spending in their various needs. Besides, the household businesses are also affected as the profits are dug on reducing the business money available for spending. The overall effect is discouraging discretionary spending. A graphical representation of the policy follows to give a more concise illustration which boosts the understanding of the policy. In the above graph, the government at reducing the demand (purple curve) to help reduce chances of inflation, the required level of demand being the red curveAD1. The yellow part illustrates the inflationary gap. However, with reducing the Demand level through tax cuts, the government is reducing the number of jobs available thus creating another problem as it solves one. Expansionary To achieve the expansionary policy the government has two options. One is increase it’s spending or two offer tax cuts. Effects Raising the government spending ensures that the level of demand is raised to a higher level; this is because the government is large enough and has control of a significant amount of funds enough to trigger the overall demand of goods and services once it supplements the private demand.(Mont pp. 76). Besides Aggregate Demand (D) = Private demand (households and businesses) (P) + Government expenditure (G). Thus an increase in either of the two P or G has a definite influence on (D). On the other hand, cutting the tax imposed on individuals increases the disposable income available to these individuals. For the business, it allows them to have greater profits as tax is considered an expense when profit computation is reduced. (Creel et al 48). The impact of businesses as well as individuals is that there are now increased demand levels for the products available in the market. Use The policy is mainly used to help overcome the threats of an apparent recession which is overcome by increasing the demand levels availing resources to the country as well as government to spend on various projects. The above diagram seeks to show how the expansionary policy works with the supply marked by AS curves. The best time to use the policy would be at the point where the supply curve is flat which would cause a minimal change in price in relation to the increase in output. On the other hand, the aggregate demand curve would move to the right due to an increase in government spending or tax cut. Proponents of Fiscal policy Fiscal policy was developed by a post classical economist known as Maynard Keynes who sought to offer a solution to help overcome the problems brought about by the Great Depression. (Mont pp.86). Keynes sought to explain that Government spending has an effect on the Aggregate Demand. The other point by Keynes was on the tax policy which he argued that a tax cut would increase the disposable income increasing consumption. The final argument based on the above assertions was that changes in Aggregate Demand are the causes of disturbances in the economic cycles. He therefore said that the way to stabilize the economy was through use of fiscal policies. In times of recession, the government ought to increase spending and vice versa in times of inflation. (Creel et al pp. 34). Reasons why fiscal policies fail. The use of Fiscal policies is not always effective especially for stabilization due to existence of a lag. This lag referred to as an inside lag is the gap existent between the actual time of implementation and time of approval by the government through congress. This requires action of the policy when the effects are already too wide spread for the policy to have any significant effect. However, this can be overcome by use of economists who would offer timely advice to Congress and the government for purposes of approval. References Weil, David (2009). The concise Encyclopedia of Economics: Fiscal policy; http://www.econlib.org/library/Enc/FiscalPolicy.html, Retrieved November, 9, 2009. Creel, J and Sawyer, M (2009) Current Thinking on Fiscal Policy, Palgrave Macmillan. Monti, M (2003). Fiscal policy, Economic adjustments, and financial markets. International Monetary Fund. Read More