Economists define fiscal policy as government policies that directly affect tax and interest rates. According to Kennedy, (2010), fiscal policies also dictate government spending as an effort to manipulate the general economy of a country. According to Perry, Serven and Suescun (2008), this is termed as cyclically adjusted tax revenue or government spending since external market forces will still naturally lead to fluctuations in the general economy and tax revenue. This in turn leads to a different form of government spending that alters a deficit situation. It is relevant to understand fiscal policy due to its varied and broad economic effects that have great impact on world economies. The question of the relevance of fiscal policy to the American economy as used by the American government and specifically in combating the effects of recession, inflation and the fluctuating of prices can be explained as follows:
Fiscal policies are used by governments to manipulate aggregate demand levels in their respective economies for them to achieve their desired economic growth levels, lower unemployment rates, lower inflation rates as well as to achieve general price stability in their markets.
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In times of recession or during low activity in the economy Keynesian economists are of the opinion that an increase in government spending and a subsequent lowering of taxes will positively influence aggregate demand. According to Kennedy (2010), an example is where due to the effects of a budget deficit of $413 billion in 2004 due to increased government spending, there was a $1.35 trillion tax cut to mitigate its effects. In case of budget surplus where the total tax revenue is more than government spending, this surplus can be used to stabilize commodity prices in case of high inflation or too slow down economic growth. According to Carson, Thomas and Hecht, (2005), Keynesian economists theorized that reduction of government spending has a direct impact on aggregate demand by reducing it due to the decrease of money in circulation leading to stability in prices.
An example is between the year 1998 and 2001, the federal budget recorded a surplus of $236 billion by the end of this period. This, however, did not last due to the terror attacks of 9/11 there was a budget deficit of $413 billion in the year 2004 due to increased military spending. Some fiscal policies however have negative long run effects that come after their short term remedies. Such is the case where governments result to fiscal stimulus as a policy, where the government experiences a budget deficit.
This deficit is covered by government borrowing, either domestic or external through the issue of government bonds, which then leads to an increase in the demand for credit in the economy. The increase of aggregate demand leads to the cost of credit going up which leads to lowered spending in the economy. According to Kennedy, (2010), low spending translates to lower tax income due to reduced business. Hence, this further increases the budget deficit in the long run. This is commonly referred to as crowding out. This was mainly seen between 1970 to 1997 where government efforts to mitigate the effects of oil price shocks, inflation and recessions led to a long term accumulation of deficit that topped to $290 billion by 1992. Other fiscal policies such as the expansionary fiscal policy decrease the exports from a particular economy which further impacts negatively on income and national output.
According to Hansen, (2003), this decrease in exports and subsequent increase in imports is due to the appreciation of a country’s currency. This makes its exports more expensive and other countries imports cheap. According to Carson, Thomas and Hecht, (2005), this phenomenon is a direct result of government borrowing and the competition for credit that is created with other local companies that also need external funding. High interest rates make the bond market to be lucrative and foreign investors rush to invest in the country.
To invest in a country’s government bonds a foreigner needs to acquire local currency and this demand for local currency is the root cause of the currency’s appreciation. This was especially evidenced in the 1970s after the gold standard was lifted and the dollar floated. The result was inflation and unstable oil import prices followed by recession as Americans lost jobs due to reduced demand for local goods and services. The other challenge posed by fiscal policy is where it utilizes the resources that are already in use in the economy. According to Nell and Forstater, (2003), this leads to increase in demand hence increase in prices. The resultant effect is an increase in inflation therefore defeating the logic behind the fiscal policy in the first place. It is, therefore, advisable to increase government spending as a fiscal policy only for idle resources for instance to reduce direct unemployment as was evident after the depression in 1939.
Fiscal policies have been in use in the United States even before the depression though it catalyzed the use of fiscal policies as the government realized that the economy could not balance itself with the traditionally recognized forces, supply and demand.
There was a need for government to be actively involved in the economy in order to mitigate the effects of wild economic forces that were experienced during the depression. There have been, however, varied debates that have divided congress over the years. Some of the fiscal policies adopted had positive results while others led to even more negative repercussions.
All these were in the quest to curb the effects of recession, inflation and the fluctuating of prices in the economy.
Carson, R., B, Thomas, W., L., & Hecht, J. (2005). Macroeconomic Issues Today: Alternative Approaches. New York: M.
E.Sharpe. Hansen, B. (2003). The Economic Theory of Fiscal Policy, London: Routledge.
Kennedy, P. (2010). Macroeconomic Essentials: Understanding Economics in the News, Massachusetts: MIT Press. Nell. E.
, J & Forstater, M. (2003). Reinventing functional finance: transformational growth and full employment. New York: Edward Elgar Publishing.
Perry, G., Serven, L., & Suescun, R. (2008).
Latin American development forum, Fiscal policy, stabilization, and growth: prudence or abstinence. Washington DC: World Bank Publications.