Fiscal policy

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Fiscal policy is the economic term that defines the set of principles and decisions of a government in setting the level of public expenditure and how that expenditure is funded. Fiscal Policy and Monetary Policy are the macroeconomic tools that governments have at their disposal to manage the economy. Fiscal Policy is the deliberate change in government spending, government borrowing or taxes to stimulate or slow down the economy. It contrasts with monetary policy, which describes the policies about the supply of money to the economy.

1 Methods of raising funds
- 1.1 Funding of deficits
2 Economic effects of fiscal policy
3 See also
4 External links

[edit] Methods of raising funds

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.

This expenditure can be funded in a number of different ways:

Taxation of the population
Seignorage, the benefit from printing money
Borrowing money from the population, resulting in a fiscal deficit.

[edit] Funding of deficits

A fiscal deficit is often funded by issuing bonds, like Treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too great, a nation may default on its debts, most usually to foreign debtors.

[edit] Economic effects of fiscal policy

Fiscal Policy is used by governments to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment and economic growth.

Keynesian economics suggests that adjusting government spending and tax rates, are the best way to stimulate aggregate demand. This can be used in times of recession or low economic activity as an essential tool in providing the framework for strong economic growth and working toward full employment. However, such policies have commonly resulted in deficite spending.

During periods of high economic growth, a budget surplus can be used to decrease activity in the economy. A Budget surplus will be implemented in the economy if inflation is high, in order to achieve the objective of price stability. The removal of funds from the economy will, by Keynesian Theory, reduce levels of aggregate demand in the economy and contract it, bringing about price stability.

Despite the importance of fiscal policy, a paradox exists. In the case of a government running a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing or the printing of new money. When governments fund a deficit with the release of government bonds, an increase in interest rates across the market can occur. This is because government borrowing creates higher demand for credit in the financial markets, causing a lower aggregate demand (AD) due to the lack of disposable income, contrary to the objective of Budget Deficit. This concept is called crowding out.