Fiscal Policy In A Nutshell

Fiscal Policy In A Nutshell September 20, 2011

Getting out of a recession is easier said than done.  Some economists would rather see the economy work its way out naturally without government intervention.  Others (particularly Keynesian economists) believe that the best way to get out of a recession is through government intervention via fiscal policy.  Put simply, fiscal policy is the government’s attempt to tax or spend its way out of a recession.  We hear the term tossed around in the news all the time, but what does it really mean?  Debt, deficit, taxation, spending, – all are important factors that help shape fiscal policy, but they can sound like Greek to the average person trying to decipher economic reports.

Here’s a ‘down to earth’ look at the factors that make up fiscal policy.  Remember, this is under the assumption of the Keynesian model which views government spending as a way to get out of a recession.  (Not my view necessarily, but it’s what this government’s fiscal policy is based on)

Assumption:  Government spending and investment spending are considered to have the same effect.  When the government pumps money into the economy, it is thought to have the same effect as an increase in private investment would with respect to helping the economy reach equilibrium (a balance).  The goal is to increase aggregate demand – the total amount of goods that people actually want to buy, which will create more jobs and help stimulate the economy even more.  This is the spending aspect of fiscal policy and doesn’t take taxation into account.

Assumption:  If government increases taxes then supply of labor, capital and other resources will decrease.  Another way to look at it is this: when the government introduces a tax cut, they’re hoping to stimulate the economy by increasing aggregate (total) supply.  By doing so, total output of goods increases, prices should fall, and demand should increase as well.

The government can implement a change in both spending and taxation with the goal of encouraging consumers to spend.  The ultimate hope is to create more demand for goods thus requiring companies to hire, which lowers unemployment.  Unfortunately, with unemployment still hovering near 10%, the current fiscal policy doesn’t appear to be working.

Other parts of fiscal policy that should be mentioned:

Government Deficit: To calculate a government’s deficit, you simply subtract taxes from what the government is spending.  Think of your own budget.  Taxes are the government’s income.  What it spends is like your expenses.  To find out the deficit (what is lacking), take your expenses and subtract your income from it.

For example:

Household expenses (government spending): $4,000 each month

Household income (government collecting taxes): $3,000 each month

Deficit = $1,000

In all reality, a deficit is a delayed tax that future taxpayers will end up paying later.

Government Debt is just as it sounds – how much a government owes.  It’s the total of all that it has borrowed and not yet repaid.  Each year, the debt is increased by the previous year’s deficit.  Currently, the US debt is over $13 Trillion.

There’s a lot to consider when a government tries to implement fiscal policy to correct the economy.  Unfortunately, there’s a lag in the results, so it’s difficult to see if policies are working right away.  This is one of the main reasons as to why it’s so difficult to find the balance between spending and taxation within an economy.

Does this give you a little clearer view of some of the terms used to explain fiscal policy?  Ask any questions below – they might spur a new article!

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