What Is Fiscal Policy - Essay Example

Fiscal Policy a) What is fiscal policy; and why do fiscal deficits and increases in government debt occur? Fiscal policy Fiscal policy indicates how the government attempts to realise revenue, spending and managing the deficit. There are several methods adopted by a government in taxation, public expenditure and public debt for achieving the macroeconomic goals. The macroeconomic goals of a government include high levels of employment and business activity, stability in prices and distribution of wealth and promotion of economic growth. Government initiates several policy measures in response to the developments in the economic system in association with the monetary policies of the central bank. “For example, the policy reaction in the US to the sub-prime crisis has used progressive cuts in interest rates in an attempt to influence the real behaviour of the economy, not just the price level, while fiscal policy has been used in an attempt to stimulate expenditure” (Lipsey, 2008). The fiscal stimulus package of the US can be considered as a strategy of ‘Pump Priming’ due to the priming effect intended by the government in the economic process. “The American Recovery and Reinvestment Act of 2009 distribute funds in three ways. Since its enactment in February 2009, $774.7B has been paid out, by way of tax benefits $290.7 B, Contracts, Grants and Loans $ 246 B and Entitlements $ 238 B” (RECOVERY.GOV, 2012) Fiscal deficit Excess of government expenditure over revenue is called fiscal deficit. Managing the budget to adjust revenues, expenditures and public debt is necessary for achieving full employment without inflation; at least it is a balancing act with such intentions on the part of the government. When the economy is in down trend, the need for compensatory spending by the government arises. In that case, it should be a deficit budget, and on the other hand, during times of stability and growth, surplus budget is preferred. If the government aims full employment, which in turn is expected to reduce the level unemployment benefits given to people, budgetary balance carries less importance in the government’s policies.  “…the president's proposals generate a federal deficit of $900 billion in fiscal 2013. If it is verified, that would be America's first deficit of less than $1 trillion since the 2008 fiscal year. It would also represent a reduction in the deficit, as a share of GDP, from 8.5% to 5.5%” (R.A., 2012).  Why do fiscal deficits and increases in government debt occur? There are multifarious factors at play which determines the fiscal deficit and increase in government debt. The decrease in tax revenues and increase in public expenditure causes budget deficits which lead to increase in public debt. Increase in public borrowing by the government sucks the liquidity in the economy, and therefore, this should be effectively used as a tool to combat inflation and regulate the speed of the growth to avoid overheating in the economy. However in reality, increase in non-plan expenditure by the government over the period of time has become the primary cause for increase in government debt. The non-plan expenditure has a tendency grow larger and larger due to various reasons such as increase in government salaries, departmental expenses and government pensions. Public expenditure is an important instrument of fiscal policy with effects on increase and decrease of income, output and employment in an economy. This policy is closely linked to private investment and inversely proportional to it. Also, the disequilibrium between savings and actual investment is sought to be balanced by public spending. Therefore, public borrowing program is employed to combat against inflation and depression through borrowing and repayment respectively. The built-in stabilizers in the system, for example, increase in tax revenues enables the government to reorient its policies in line with the economic cycles, in this case to repay the debts at the time of depression to increase liquidity in the economy. Contra-cycle policy During the expansion phase of an economic cycle, taxes are increased and government spending is cut. The government borrowings are repaid by using the increase in tax revenues. This is required to regulate the speed with which the economy grows to avoid overheating in the economy. During the contraction phase, the policies of the government are reversed. The taxes are cut and the government’s spending is increased to reduce the effect of recessionary pressures in the economy and to accelerate the revival process in order to create multiplier effect in the economic system, though there is an attendant risk of inflation in the case of increased public spending. The private investment which tends to be lower during the phase needs to be compensated by government spending. b) Why have some governments experienced sovereign debt crises; and to what extent might efforts to reduce government debt risk creating double-dip recessions? Sovereign debt crisis A government resorts to borrowing by issuing bonds against the external debt in foreign currencies for reviving the domestic economy or for capital requirements for the growth of the economy. The fluctuations in foreign exchange make the borrowings riskier. The difficulties in repayment of this sovereign debt will affect the sovereign credit ratings of a country adversely. The magnitude of the crisis could be understood from the vulnerable economic conditions of Greece. The country could be bailed out only through the European Union’s consistent efforts to prevent a deeper world economic crisis, if it remains unresolved. Wiesmann (2012) writes, “In their latest agreement to save Greece from insolvency, eurozone governments want to cut interest rates on and extend the duration of Athens’ bailout loans. Their aim is to cut Greece’s sovereign debt to 124 per cent of gross domestic product by 2020, about 20 percentage points lower than the government’s current debt path.” The sovereign debt crisis is closely related to balance of payment position in a country. Kohler, (2012, p. 14) states “As we know by now, the issue became relevant at the very beginning of the balance of payments crisis in 2007, when the net lending positions of the private and public sectors in the so-called GIPS countries (Greece, Ireland, Portugal and Spain) could no longer be matched by private capital imports.” The severe imbalances in the exports and imports in a country and accumulation of debts in foreign currencies over a period of time both by the government and the external borrowing by private sector enterprises eventually lead to sovereign debt crisis, resulting into repayment problems. It will be very difficult for the country to borrow funds in the international markets due to adverse credit ratings which might seriously affect the economic growth of the nation as the countries are interdependent for their growth and development due to increasing trends in globalization and liberalization. Movement of funds mostly denominated in US Dollars caused due to investment in shares and securities by the foreign institutional investors and the hedge funds globally is on the rise. When these global players pull out money from a country when already there is acute crisis in balance of payment front, it will lead to depreciation of the domestic currency drastically. A country’s growth which is depending partly on import of goods and services will be affected due to unfavourable fluctuations in foreign exchange. Government debt and recession When an economy shows signs of recession the government needs to be proactive in taking steps based on the economic indicators. The government should be ready with a program for public spending related to infrastructural development like laying of roads, construction of bridges, renovation of the public properties and augmenting the water resources. This will create direct employment opportunities to the people in a big way which will act as a catalyst for the revival of economy through increasing demand for goods and services. This process encourages private investment indirectly and there by the level of unemployment is greatly reduced. Public borrowings already made when the economy was in robust condition to curtail inflationary pressures and regulate the speed of the growth could be effectively used for public spending. It is important to note that the borrowing program should envisage use of idle money available in certain pockets of the economy. However, there are limitations to borrowing. Government’s public borrowing needs to be at reasonable level and comply with certain norms. Debt to GDP ratio within reasonable limits means that the economy of the nation is sound and balanced. It indicates that productivity level in the economy is very high. This factor increases the government’s ability to borrow more, if necessary. Otherwise, the government’s borrowing program will be counter-productive as it impairs liquidity in the system which could deepen the recessionary fears in the economy. This will be accentuated by the central bank’s monetary policy, if it is under pressure not to reduce the interest rates on account of inflation. The decrease in money supply due to government policies and monetary policies of the central bank could impair credit off-take which will affect the economic growth and the fresh private investments are required for revival of the economy. Moreover, if the government bonds are bought by middle class people, their disposable income will come down proportionately. In such a case deflationary effects will set in due to decrease in private consumption. Decrease in private consumption reflects in demand for the goods and services and the private investment comes to standstill due to lack of demand for goods and services manufactured. If the economic policies of the government have not yielded the desired results and the momentum towards recession could not be prevented effectively by the interventions of the government and the central bank, stagflation sets in. The stagnation coupled with inflation, as it is called as stagflation in its wake brings in several issues like inflation, unemployment and lack of liquidity in the system to the fore. The simultaneous effects of higher level of unemployment and inflation in an economy are challenges to the government and the monetary authorities. Recession followed by recovery for a brief period is again followed by deeper recession or double dip recession as it is called may lead to triple dip recession as well. Usually, the recovery process in such cases will be very slow and time consuming. It may take several years for the economy to come back to the revival path. The borrowings made by the government are increasingly spent on non-plan expenditure. Also, these expenditures could not be regulated based on the economic situations. Since the proportion of spending on plan expenditure has come down drastically in most of the economies due to factors like subsidies and unemployment benefits in addition to increase in salaries, expenses and pensions benefit faced by the government, it is not in a position to effectively intervene in the economic process. Higher proportion of budgetary allocation to plan expenditure will increase employment and create multiplier effect in the economy. Also, these expenditures can be gainfully used for the establishment of infrastructural facilities for the growth of economy. Borrowing can be resorted for curtailing inflationary pressures and to slow down the economy when its growth is very fast. Public spending at the time of depression is inevitable to revive the economy. Therefore, during the periods of slowdown in an economy the efforts to reduce government debt instead of much needed public spending will lead to double-dip recessions. References Kohler, W, 2012, THE EUROSYSTEM IN TIMES OF CRISES: GREECE IN THE ROLE OF A RESERVE CURRENCY COUNTRY? THE EUROPEAN BALANCE OF PAYMENTS CRISIS, CESifo Forum 2012, http://www.cesifo-group.de/portal/pls/portal/docs/1/1215229.PDF Lipsey, RG, 2012, EVOLUTIONARY ECONOMICS, THE PHILLIPS CURVE AND THE INCREDIBLE DISAPPEARING NATURAL RATE OF UNEMPLOYMENT, Presented at The Session Keynes at 125 The Canadian Economic Association Meetings Vancouver B.C., June 6­8, 2008, http://economics.ca/2008/papers/1085.pdf RECOVERY.GOV, 2012, OVERVIEW OF FUNDING, http://www.recovery.gov/Pages/default.aspx R.A., 2012, The Federal Budget: Tax and Build, The Economist, http://www.economist.com/blogs/freeexchange/2012/02/federal-budget?zid=295&ah=0bca374e65f2354d553956ea65f756e0 Wiesmann, G, 2012, Germany approves new Greek bailout, The Financial Times, 30 November 2012, http://www.ft.com/intl/cms/s/0/b0349fbe-3adf-11e2-b3f0-00144feabdc0.html#axzz2DukiBY2L Read More