Introduction to fiscal policy
Fiscal policy has two possible roles as far as controlling aggregate demand is concerned.
First Role
The first is to remove any severe deflationary or inflationary gaps. In other words, expansionary fiscal policy could be used to prevent an economy experiencing a severe or prolonged recession.
The Great Depression of the 1930s or in the east and south-east Asia, Russia and Brazil in the late 1990s. It has also been used for this purpose in Japan in recent years and in the USA in 2001/2 and in 2007/8 and around the world in 2008 when substantial tax cuts and increased government expenditure were used by many countries including the UK, to combat the onset of recession.
*The following links are for enrichment purposes only
*The following links are for enrichment purposes only
Likewise, deflationary fiscal policy could be used to prevent rampant inflation, such as that experienced in the 1970s. To summarise: the first role is to prevent the occurrence of fundamental disequilibrium in the economy.
Second role
The second role is to smooth out the fluctuations in the economy associated with the business cycle. This involves reducing government expenditure or raising taxes when the economy begins to boom. This will dampen down the expansion and prevent 'overheating' of the economy, with its attendant problems of rising inflation and a deteriorating current account balance of payments. Conversely if a recession looms, the government should cut taxes or raise government expenditure in order to boost the economy. If these stabilisation policies are successful, they will amount merely to 'fine tuning'. Problems of excess or deficient demand will never be allowed to get severe. Any movement of aggregate demand away from a steady growth path would be quickly 'nipped in the bud'
Recap
This is a recap on all the economic terms used in the explanations above that you may have forgotten or are unclear of.
Business cycle |
There are 4 phases to the business cycle, which is defined by periodic fluctuations of national output round its long-term trend
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Moving on...
Before we look at just how fiscal policy can be used, it is important to understand some of the terminology of government spending and taxation