Fiscal Policy 

What is “Fiscal Policy”?

Fiscal policy is the use of government expenditure and taxation policies to promote the strong and sustainable growth of an economy. The specific goals of fiscal policy are typically managing demand, distribution of income and wealth among sectors and individuals, and allocation of resources between sectors and industries. All these goals contribute to stabilizing the economy and support macroeconomic conditions for long-term growth.

Basically, the fiscal policy is implemented to help create a stable economic environment, which is imperative for enabling households to feel secure to consume and save, and enabling firms to focus on undertaking capital expenditures, investments, repaying debt, and making profits. Unlike monetary policy, fiscal policy looks at an economy from top-down i.e. on a macroeconomic level. It uses macroeconomic insights and data points to decide on appropriate levels of government spending and taxation.

Fiscal Policy – Expansionary and Contractionary

An expansionary fiscal policy attempts to stimulate aggregate demand, to boost or increase aggregate output (and reduce unemployment) by increasing government expenditure and/or reducing taxes. Conversely, a contractionary fiscal policy is achieved by reducing government expenditure and/or increasing taxes to dampen aggregate demand to lower aggregate output (which leads to higher unemployment).

Such use of fiscal policy (expansionary or contractionary) in an economy, to counter short run fluctuations in economic activity and to enhance or slow down the growth rate of output – GDP (and inflation too), essentially involves attempts to influence aggregate demand (in relation to aggregate supply) in the short run.

The equation for GDP – Expenditure side (reflecting aggregate demand) is given below:

Y = C + I + G + (X-M)

Now if we slightly alter the equation:

Y = C (Y – T) + I + G + (X-M)

Fiscal policy impacts aggregate demand directly by changing (increasing or lowering) government expenditure (G) and/or indirectly through changing (increasing or lowering) taxes (T) – which affects the disposable income of households and can therefore lead to changes in consumer spending.

In the case of an expansionary (contractionary) fiscal policy, the government can directly increase (reduce) government expenditure and/or lower (increase) taxes which increases (reduces) the disposable income of households. This in turn should then have a positive (negative) effect on consumer spending and stimulate (reduce) aggregate demand. This can also lead to higher (lower) aggregate output – GDP (incomes and employment) and upward (downward) pressure on prices.

Fiscal Policy Multipliers (FPM)

When fiscal policy is prescribed to influence aggregate demand and hence aggregate output in an economy, policymakers are always interested in knowing by how much will aggregate output ultimately change, as a result of a change in either government expenditure or taxes, or both. Fiscal Policy Multipliers can provide such answers (estimates).

Three Types of Fiscal Policy Multipliers

A. Expenditure Multiplier: quantifies how much will aggregate output ultimately change, as a result of an initial change in government expenditure (i.e. stimulus).

B. Tax Multiplier: quantifies how much will aggregate output ultimately change, as a result of a change in taxes.

C. Balanced Budget Multiplier: quantifies the combined impact of a change in government expenditure and taxes on aggregate output.

Fiscal Policy –  Expenditure Multiplier (FPM), Example

Stated below is the Fiscal Policy (Expenditure) Multiplier (FPM) formula:

FPM = (1/1-MPC) *ΔG

MPC = Consumers’ marginal propensity to consume

ΔG = Increase in government expenditure

Assume that in an economy, the government unveils a fiscal stimulus of $1 billion and the MPC is 0.65. The overall increase in GDP (Y) will likely be $2.9 billion, as the FPM is 2.9. However, it is important to note that this will generally be in stages and not at one go. In addition, given that the MPC is 0.65, when consumers receive the initial $1billion, they will likely spend $650 million, initiating another, smaller round of stimulus. The recipients of the $650 million, will in turn spend $422.5 million (out of this income of $650 million) and save the rest, given that the MPC remains 0.65.

The successive rounds of consumer spending will get smaller and smaller. Ultimately, the total increase in national income will likely be $2.9 billion, as a result of the initial $1 billion of fiscal stimulus, based on estimates and assumption using the FPM of 2.9 and MPC of 0.65.