Fiscal policy

Definition: deliberate intervention by government to manage government spending and

government income to achieve particular economic and social outcomes. The
instruments/tools of fiscal policy are tax and government spending. The level, timing and
structure of these policies can be adjusted.
Public expenditure include spending from taxation and borrowing which take the form of
current and capital spending undertaken by the central government, local government and
or national industries. Spending also involves:
1. Spending on goods and services and salary
2. Tranfer payment
-

pension

subsidies

How government expenditure is financed:

1. Tax
2. Borrowing
3. Sale of assets
Expansionary fiscal policy taxes decrease and government spending increases thus
increasing AD, increasing employment and increasing AD.
Contractionary fiscal policies - taxes increase and government spending decreases thus
decreasing AD, decreasing employment and decreasing AD. This reduces inflation as
well.

Curve

Fiscal policy and unemployment

To reduce unemployment G increases and T decreases causing AD to increase, there is
a need to meet this increase in AD which increases production and reduces
unemployment.
Curve pg 119

Fiscal policy and inflation

Demand pull inflation can be reduced by increasing tax and reducing government
spending. Consumption will fall causing AD to fall and prices falls.
Curve pg 121

Fiscal policy and BOP

Increasing the price of domestic goods by increasing tax and cutting spending reduces
demand for them both locally and internationally which worsens the BOP as local
consumers and foreigners choose cheaper products in other market. Government
spending and reduction of tax to increase production will increase exports hopefully at a
greater rate than imports resulting in a favourable BOP. Of course government could
directly increase taxes to reduce importation.

The nature of the budget

The budget consists is divided into revenues and expenditures. It is an overall statement
of a governments plan for its own spending and tax revenues. It is an indicator of the
state of the economy, taking into account government spending, taxation, AD levels and
revenues.
Type of Budgets
1. Balanced Budget total revenues equal total expenditure
2. Surplus Budget revenues are greater than expenditure
3. Deficit Budget when tax revenues are less than expenditure.
Government expenditure includes:
1. Infrastructure improvement
2. Roads construction and schools
3. Spending on the different sectors health, education, tourism, mining etc.
Revenues include:

1. Privatization proceeds
2. Income tax, cooperation tax, GCT
3. Rent from government buildings and land
4. Profits from nationalized industries
5. Loan from domestic/ external financial institutions/organizations
The Balanced Budget Multiplier =1
This occur when a change in government spending equals the change in tax (G =T) or
(Y =G). it is possible that with a balanced budget a country can experience an increase
in national income.
Eg If T = $20B and G = $20B, when the MPC = 0.8. MPC represents consumer spending
$20B x 0.8 = $16B, $4B is saved. $4B x 1/1-0.8 = $4B x 1/0.2 = $4B x 5 = $20B
The national income will increase by $20B which is the same as the initial injection by
the government.
Methods of financing a budget deficit
1. Treasury bills these are short term borrowing by the government and are
redeemable after 3 months (internal)
2. Bonds these are long term borrowing by government (internal)
3. The government also borrows from abroad to finance a deficit.
Lags and potency of fiscal policies
Lag is the time required to approve and implement fiscal legislation and may hamper the
effectiveness and weaken fiscal policy as a tool of economic stabilization.
They include:

1. Recognition/decision time it takes to recognize/determine the exact nature of an

intervention. (eg a recession)
2. Implementation/ administration the time period between making a decision and
actual implementation. (plans to stimulate the economy)
3. Impact the time it takes to have an impact. (stimulus package)
1. It is a lag to identify the problem. You were in recognition lag until you identify the problem.

2. Action lag is also known as INSIDE LAG. after identifying the problem Govt make some
polices which has to be approved from senate or assembly or any other governing body. It is
called Action Lag. Normally it takes long time.

3. Once govt adopt the policy, the time period between adopting the policy and its impact is
called impact lag and it is also called OUTSIDE LAG. normally it is shorter than Action Lag.

Lags
Recognition
Administration
Impact

Monetary Policy
same

Fiscal Policy
Same time to identify the

Easy to implement
Takes a longer time to be

problem
Takes time to Implement
Shorter time to be felt

felt
Potency of fiscal policy
1. Crowding out effect
If the government implements expansionary fiscal policy by reducing taxation, or
increasing government spending then this will lead to a budget deficit. To finance this
deficit the govt. will have to borrow. This puts upward pressure on the rate of interest
as the govt. competes for limited funds with the private sector. As the rate of interest

increases private investment and consumption are discouraged and this leads to a fall
in AE. In other words, the high level of govt. spending crowds out private sector
spending. Overall this counteracts the impact of expansionary fiscal on the economy
making it less effective.
2. Lack of excess capacity
Where the economy is at full capacity and all resources are fully utilized an increase
in AD as a result of expansionary policies will simply lead to inflation. However, in
an economy where resources are not fully employed and there is excess capacity, an
increase in AD stimulates the economy and effectively increases output without
inflation.
Automatic and discretionary stabilizers
Discretionary
Deliberate changes in G and T to affect the size of the budget deficit/surplus
Automatic
Government spending that automatically increases/decreases along with the business
cycle without legislation having to be passed. Decreases in aggregate income cause
the unemployment rate to increase resulting in an increase in welfare payments.
Decreases in Y cause tax revenues to fall faster than the national income.