Fiscal policy is a macroeconomic policy that helps manipulate the economy through government revenue (tax) and government spending. The fiscal policy is needed to aid macroeconomic conditions such as aggregate demand, employment, inflation and economic growth. This is also the sister strategy to the monetary policy in which the Reserve Bank of Australia influences the nations money supply.

 

The idea of fiscal policy is to find the balance between taxation and expenditure. By increasing taxation, consumer spending decreases dramatically due to insufficient funds and economic output (GDP) falls, unemployment rises and ultimately government taxation will reduce in the long run. If this method is enforced without finding a counteracting force such as spending on the economy again, there will be chaos!

 

The fiscal policy comes in two forms to flatten the business cycle (minimise fluctuations):

Expansionary Fiscal Policy (Speed up economy)

Let’s say that the economy is slow and stagnant. The expansionary fiscal policy stance will help aid the economy back into shape and increase growth. When the economy is in a state of low consumer spending, high unemployment and low economic growth, the expansionary stance means that the government can reduce government revenue (Taxation) to allow for more spending. With increased spending, the economy is back on its feet. The government can also chosen to increase government spending in infrastructure, welfare payments and schemes to produce more jobs to reduce the unemployment rate. Both of these methods under the expansionary stance allow individuals to spend and stimulate the economy through demand.

 

Contractionary Fiscal Policy (Slow down economy)

Let’s say that the economy is growing too quickly. The contractionary fiscal policy stance will help aid the economy back into shape to reduce growth rates. When the economy is in a state of high aggregate demand and high consumer spending which will raise the inflation rate, the contractionary fiscal stance is the way to go. The government can increase government revenue (taxation) to limit consumers disposable income which will discourage spending and keep inflation within or around its target band. Or the government can also choose to decrease government expenditure to limit the amount of new jobs in the economy. This will result in an increase in the economy’s unemployment rate to control aggregate demand.

 

Budget outcomes

If the government is earning revenue from the productivity of the working population, and spending it on the economy to improve facilities. There are budgetary outcomes to consider while implementing the fiscal policy. There are three possible budget outcomes for the government

 

When expenditure is higher than taxation revenue then the budget outcome is a deficit

When taxation revenue is higher than expenditure then the budget outcome is a surplus

When taxation revenue and expenditure are equal then the budget outcome is balanced

 

If you find that hard to digest, use the table below !

 

Budget Outcome
Gov Revenue (Taxation) <Gov Expenditure Deficit (-)
Gov Revenue (Taxation) >Gov Expenditure Surplus (+)
Gov Revenue (Taxation) =Gov Expenditure Balance

Financing a Budget Deficit

There are three main ways to financing a budget deficit

  1. The government can choose to borrow from the reserve bank. By increasing money supply in the economy to cover the government revenue shortfall, demand pull inflationary pressures will cause inflation to rise. Thus making this method suitable for when the economy is resting on an inflation rate of below or at 2%.
  2. The government can also choose to buy and sell bonds and securities. By doing so will keep the money supply constant and demand pull inflationary pressures will not impact the economy as above. However, borrowers and lenders will fight for limited funds in the economy which raises interest rates. This is referred to as the crowding out effect.
  3. The government can also choose to borrow from overseas. Although this means internal economic problems such as inflation and crowding out are not a concern for the economy, the foreign debt will accumulate and impact future generations of the government as well as the society in order to repay this debt.

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