Fiscal Policy 101

Here we will look at how the fiscal policy works, how it must be monitored, how its implementation affects different people in an economy, followed by my opinion of it.

What is the Fiscal Policy?
According to Investopedia.com the fiscal policy is the government spending policies that influence macroeconomic conditions. Through fiscal policy, regulators attempt to improve unemployment rates, control inflation, stabilize business cycles and influence interest rates in an effort to control the economy.





How Does the Fiscal Policy Work?
The fiscal policy is based on the theories of British economist John Maynard Keynes (1883–1946). Also known as Keynesian economics, this theory fundamentally states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and government spending. This influence curbs inflation (generally considered to be healthy when between 2-3%), increases employment and maintains a healthy value of money. Fiscal policy is very important to the economy. For example, in 2012 many people worried that the fiscal cliff (a simultaneous increase in tax rates and cuts in government spending) was set to occur in January 2013, and would send the U.S. economy back to recession. This problem was avoided by the passing of the American Taxpayer Relief Act on January 1, 2013.





Should the Fiscal Policy be Monitored?
Firstly, you must consider for the objective of fiscal policy, which is to find a balance between changing tax rates and government spending. For example, stimulating a sluggish economy by increasing spending or decreasing taxes runs the risk of causing inflation. This is due to an increase in the amount of money in the economy, followed by an increase in consumer demand, which can result in a decrease in the value of money.


Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down and businesses are not making steady profits. The government therefore decides to fuel the economy and increase aggregate demand by decreasing taxes, which gives consumers more spending money, while increasing government spending in the form of buying services from the market (such as building roads or schools). By paying for these services, the government then creates jobs and wages that are pumped back into the economy. Meanwhile, overall unemployment levels will decline. The government is now practicing expansionary fiscal policy. Now, with more money in the economy and fewer taxes to pay, consumer demand for goods and services increases. This revives businesses and turns the cycle around from sluggish to active.

However, if there are no brakes on this process, the increase in economic productivity will cross over a fine line and lead to too much money in the market. This surplus decreases the value of money while pushing up prices (because of the increase in demand for consumer products). Hence, inflation will exceed the reasonable level. This is why, fine tuning the economy through fiscal policy alone can be a difficult means to reach economic goals. If not closely monitored, the line between a productive economy and one that is drowning in inflation can easily be lost.

The economy may need a slowdown when inflation is too strong. In this situation, the government can use the contractionary fiscal policy to increase taxes to basically take money out of the economy. Fiscal policy could also order a decrease in government spending and thus decrease the money in circulation. Certainly, the negative effects of such a policy in the long run could be a sluggish economy and high unemployment levels. In hopes of evening out the business cycles, the government may continue to use its fiscal policy to fine-tune spending and tax levels.

Who Does the Fiscal Policy Affect?
Unfortunately, the fiscal policy will not affect everyone in the same manner. Depending on the political goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic downfall and rising taxes, it is this same group that may have to pay more taxes than the upper class.

Correspondingly, when the government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new road, for example, will give work and more income to hundreds of construction workers. On the other hand, a decision to spend money on building a new jet benefits only a small, specialized group of experts, which would not do much to increase aggregate employment levels.

What Does it all Boils Down to?
One of the most considerable obstacles facing policymakers is deciding how much the government should be involved in the economy. Undeniably, there have been numerous degrees of government interference over the years. Although, for the most part, it is accepted that a certain degree of government involvement is necessary to sustain a thriving economy, on which the economic well-being of the population is dependent on.

 In My Opinion
I believe that the fiscal policy is effective in democratic countries for the most simplistic reason being that government intervention is an essential component of a growing economy. Say for example a recession would take place, as consumption and investment decline, the government can boost its expenditures to offset them. This is because the government can discretionarily change its level of spending with the main objective being to return the economy to the desirable growth. Overall, despite its few flaws, I believe the fiscal policy works effectively in Canada.