The effects of any fiscal policy are not often the same for everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group.
In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class. Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers.
A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts and firms, which would not do much to increase aggregate employment levels. One of the biggest obstacles facing policymakers is deciding how much direct involvement the government should have in the economy and individuals' economic lives.
Indeed, there have been various degrees of interference by the government over the history of the United States. But for the most part, it is accepted that a certain degree of government involvement is necessary to sustain a vibrant economy, on which the economic well-being of the population depends. International Monetary Fund. Fiscal Policy. Federal Reserve. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
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This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential tool for economic stabilization. In a recession, the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put unemployed workers back to work. During a boom, when inflation is perceived to be a greater problem than unemployment , the government can run a budget surplus, helping to slow down the economy.
Such a countercyclical policy would lead to a budget that was balanced on average. Automatic stabilizers—programs that automatically expand fiscal policy during recessions and contract it during booms—are one form of countercyclical fiscal policy.
Unemployment insurance , on which the government spends more during recessions when the unemployment rate is high , is an example of an automatic stabilizer. Similarly, because taxes are roughly proportional to wages and profits , the amount of taxes collected is higher during a boom than during a recession.
Thus, the tax code also acts as an automatic stabilizer. But fiscal policy need not be automatic in order to play a stabilizing role in business cycles. Some economists recommend changes in fiscal policy in response to economic conditions—so-called discretionary fiscal policy—as a way to moderate business cycle swings.
Unfortunately, discretionary fiscal policy is rarely able to deliver on its promise. If economists forecast well, then the lag would not matter because they could tell Congress the appropriate fiscal policy in advance. But economists do not forecast well.
Absent accurate forecasts, attempts to use discretionary fiscal policy to counteract business cycle fluctuations are as likely to do harm as good. The case for using discretionary fiscal policy to stabilize business cycles is further weakened by the fact that another tool, monetary policy , is far more agile than fiscal policy.
Higher aggregate demand due to a fiscal stimulus, for example, eventually shows up only in higher prices and does not increase output at all. That is because, over the long run, the level of output is determined not by demand but by the supply of factors of production capital, labor, and technology. An attempt to keep output above its natural rate by means of aggregate demand policies will lead only to ever-accelerating inflation. The fact that output returns to its natural rate in the long run is not the end of the story, however.
In addition to moving output in the short run, expansionary fiscal policy can change the natural rate, and, ironically, the long-run effects of fiscal expansion tend to be the opposite of the short-run effects. Expansionary fiscal policy will lead to higher output today, but will lower the natural rate of output below what it would have been in the future.
Similarly, contractionary fiscal policy, though dampening the output level in the short run, will lead to higher output in the future. In a nutshell, Keynesian economic theories are based on the belief that proactive actions from our government are the only way to steer the economy.
This implies that the government should use its powers to increase aggregate demand by increasing spending and creating an easy money environment, which should stimulate the economy by creating jobs and ultimately increasing prosperity. The Keynesian theorist movement suggests that monetary policy on its own has its limitations in resolving financial crises, thus creating the Keynesian versus the Monetarists debate. While fiscal policy has been used successfully during and after the Great Depression, the Keynesian theories were called into question in the s after a long run of popularity.
Monetarists, such as Milton Friedman, and supply-siders claimed the ongoing government actions had not helped the country avoid the endless cycles of below-average gross domestic product GDP expansion, recessions, and gyrating interest rates. Just like monetary policy, fiscal policy can be used to influence both expansion and contraction of GDP as a measure of economic growth.
When the government is exercising its powers by lowering taxes and increasing their expenditures, they are practicing expansionary fiscal policy. While on the surface expansionary efforts may seem to lead to only positive effects by stimulating the economy, there is a domino effect that is much broader reaching. When the government is spending at a pace faster than tax revenues can be collected, the government can accumulate excess debt as it issues interest-bearing bonds to finance the spending, thus leading to an increase in the national debt.
When the government increases the amount of debt it issues during an expansionary fiscal policy, issuing bonds in the open market will end up competing with the private sector that may also need to issue bonds at the same time. This effect, known as crowding out , can raise rates indirectly because of the increased competition for borrowed funds. Even if the stimulus created by the increased government spending has some initial short-term positive effects, a portion of this economic expansion could be mitigated by the drag caused by higher interest expenses for borrowers, including the government.
Another indirect effect of fiscal policy is the potential for foreign investors to bid up the U. While a stronger home currency sounds positive on the surface, depending on the magnitude of the change in rates, it can actually make American goods more expensive to export and foreign-made goods cheaper to import. Since most consumers tend to use price as a determining factor in their purchasing practices, a shift to buying more foreign goods and a slowing demand for domestic products could lead to a temporary trade imbalance.
These are all possible scenarios that have to be considered and anticipated. There is no way to predict which outcome will emerge and by how much, because there are so many other moving targets, including market influences, natural disasters, wars and any other large-scale event that can move markets. Fiscal policy measures also suffer from a natural lag or the delay in time from when they are determined to be needed to when they actually pass through Congress and ultimately the president.
Unfortunately, given the inherent unpredictability and dynamics of the economy, most economists run into challenges in accurately predicting short-term economic changes. Monetary policy can also be used to ignite or slow the economy and is controlled by the Federal Reserve with the ultimate goal of creating an easy money environment. Early Keynesians did not believe monetary policy had any long-lasting effects on the economy because:.
At different times in the economic cycle , this may or may not be true, but monetary policy has proven to have some influence and impact on the economy, as well as equity and fixed income markets.
The Federal Reserve carries three powerful tools in its arsenal and is very active with all of them. The most commonly used tool is their open market operations , which affect the money supply through buying and selling U. The Federal Reserve can increase the money supply by buying securities and decrease the money supply by selling securities.
The Fed can also change the reserve requirements at banks, directly increasing or decreasing the money supply. The required reserve ratio affects the money supply by regulating how much money banks must hold in reserve.
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