The impact of fiscal policy on economic growth

The impact of fiscal policy on economic growth

1. Introduction

The purpose of the essay is to illustrate how fiscal policy has an impact on the economy. In order to appreciate the content and the theories raised, first we must understand how fiscal policy is defined. The second section explains the definition and the role of fiscal policy. The third section of the essay has a detailed analysis of the business cycle and the effects of fiscal policy. In order to critique the effectiveness of fiscal policy in an economy, we have to establish what its effects are on the economy during different periods in time. The fourth section explores the theories of John Maynard Keynes. As a passionate supporter of using government budgets to influence the level of economic activity, Keynes once stated that the best way to control the economy and the level of activity within is to simply manage the levels of public spending. This can be done by injecting money into the economy during periods of recession and holding money back during periods of economic booms or inflation. Finally, the essay evaluates the fiscal policy stance of the Australian government during the 2000 to 2009 period and the results of its policy on the economy. Overall, there is strong evidence to suggest that fiscal policy does have an effect on an economy. The difficult part for policymakers will be to choose the most appropriate policy in regards to the current state of economic conditions.

2. Theoretical framework

An increase in government spending can be used to increase aggregate demand. If this occurs when there is unemployment in the economy, then it will result in an increase in income without a change in the rate of interest and therefore will shift the IS curve to the right. If the increase in government spending occurs when there is full employment in the economy, it will have the effect of increasing the rate of interest without a change in income and therefore will shift the IS curve to the right. The use of deficit spending, such as this, would be used to further increase the full employment level of income by bringing about an increase in investments which it is hoped would make the increase in income a long-run change.

The IS-LM model provides a useful framework for understanding the ways in which changes in fiscal policy can affect aggregate demand. It shows how changes in fiscal policy can shift the IS and LM curves to alter the equilibrium levels of income and interest rates. In this model, it is assumed that prices are fixed and the full employment level of output is possible. Therefore, the methods in which fiscal policy could be used to affect economic growth are those which will change the equilibrium levels in income and will not change the full employment level of output.

A theoretical framework will be developed in this section in order to investigate the impact of fiscal policy on economic growth. Initially, the IS-LM model will be used to illustrate how fiscal policy can be used to influence aggregate demand and therefore affect economic growth. Furthermore, the Harrod-Domar model and the Solow model will be used to demonstrate how changes in aggregate demand resulting from fiscal policy can affect the long run rate of economic growth.

3. Empirical evidence

More recently, Alesina, Favero and Giavazzi distinguished between ‘painstaking’ consolidation, involving a long-lasting effort to reduce the budget deficit through a combination of spending cuts and tax increases, and consolidation plans that involve quick and decisive action. Using a variety of methodological approaches and data for 16 OECD countries from 1981 onwards, they conclude that consolidation is more likely to be successful in reducing the budget deficit and debt/GDP ratio when based on spending cuts, especially on transfers and public sector wages. The GDP growth effects of fiscal adjustments are different under fixed exchange rate regimes and monetary union membership, but in both cases fiscal devaluation (cuts in wages and increases in indirect tax to improve the balance of payments and cost-competitiveness) is deemed to be a relatively ineffective strategy for boosting growth.

As regards the shorter-term effects of discretionary fiscal policy changes, using data for 20 OECD countries from 1970–2000, Alesina and Perotti (1999) found that fiscal policy changes designed to reduce the budget deficit have contractionary effects, but that spending increases do not have a significant impact on GDP growth. They argue that deficit reduction plans typically involve politically unpopular tax increases and spending cuts, and it is the expectation of future fiscal adjustments that reduces current aggregate demand.

Empirical evidence on the impact of fiscal policy on economic performance is diverse and inconclusive, which is perhaps not surprising given the complexity of the transmission channels involved. There are significant methodological difficulties in separating the effects of fiscal policy changes from those of other factors, and in identifying the size of the effects.

4. Policy implications

The other strategy for fiscal policy is to spend more on government services or less on goods subsidies so that a given volume of employment and national income is obtained with more resources devoted to government services—and hence with a higher average quality of alternative resources used. This strategy would involve: a shift of resources, or resources in training, from the private to the government sector… in order to increase government supply capabilities in relative terms and also in terms of their productivity; a shift of resources from industries producing private are to those producing public services in order to improve the quality of government services; and an increase in the average quality of human resources used at each occupation.

If the results of this paper are accepted, that is, government services enable the private sector to obtain a higher standard of living than it could otherwise attain, the next step is to examine policy implications. The analysis in the paper indicates that there are at least three alternative strategies for fiscal policy depending on the problem involved in attaining higher employment and national income, and each strategy has certain definite implications for the kind of government service and type of taxation that should be used. Any of the three strategies can be pursued at any level of employment, but for expository purposes it is convenient to discuss each strategy under the assumption that there is substantial unemployment.

5. Conclusion

The main impact of fiscal policy on the UK economy has been to change AD. AD is the total level of planned expenditure in an economy; it is the total amount of goods and services that will be purchased at all possible price levels. An increase in government spending involves an injection of demand into the economy; it will lead to a shift in the AD curve to the right. This will lead to an increase in the equilibrium level of national income and therefore achieve economic growth. Economic growth is an increase in national income NDP over time. It results in an improvement in living standards and increased employment as labor demand will increase. It is argued that an increase in government spending will lead to a multiplied increase in national income. This is because the extra injection of demand will cause the national income to increase to a new equilibrium level. This will therefore lead to multiple rounds of increased employment and output until the effect dies out.

Fiscal policy is the use of government’s revenue and expenditure as tools to influence the economy. Through the use of government spending and taxation, this can attempt to achieve the desired economic objectives. These can include changes to the rate of economic growth, inflation, unemployment, and the balance of payments. Expansionary fiscal policy involves the government increasing spending and reducing taxes in order to increase aggregate demand (AD) and achieve economic objectives. Conversely, deflationary fiscal policy involves a decrease in government spending and an increase in taxation to reduce AD.

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