Role of Fiscal Policy in Stabilizing the Economy

Role of fiscal policy in stabilizing the economy

Fiscal policy can be defined as a means through which a government shapes its spending through taxation and government expenditure so as to monitor and influence country’s economy. This is the most efficient tool in attaining a nation’s economic objectives. To stabilize the effects of an economy, government can control its spending and taxes to influence aggregate demand and supply so as to eradicate inflationary and deflationary gaps.

During deflation, expansionary fiscal policy is used to stabilize the economy. One of the ways of doing this is by increasing government spending; this result in collective increase in entire spending that is much higher than the earlier change in spending because of the multiplier. This can be demonstrated in the following diagram .

The economy’s Equilibrium point, E1, at which the economy is operating is lower than E2 which is the full employment, thus the economy is faced with deflationary gap. Aggregate demand shifts from AD1 to AD2 when spending is increased hence the change in equilibrium to E2 along the supply curve. At this point, the economy is at full employment level since it higher than the initial output.

Tax multiplier is also another tool commonly although it is considered to be weaker than government spending multiplier. This is done by decreasing taxes. As illustrated in the diagram below, the economy is experiencing deflationary gap since it is operating at E1which is lower than E2, the full employment. By decreasing taxes, consumption and investment is enhanced hence the shift in aggregate demand curve from AD1 to AD2 along the supply curve AS. At this point the economy is at full employment.                                

In the above diagram, the economy is operating at the equilibrium. The point E1 at which the economy is operating is much higher than E2. E1 is higher than full employment E2. At this point the economy is facing inflationary gap. With an increase in taxes, aggregate demand, AD1, shifts to AD2 along the supply curve AS. At the new equilibrium E2, the economy is below full employment this is due to the reduction in output instigated by tax increase (Gruen, 2009).

In activist fiscal policy, the size of the multiplier is put into consideration as this is one of the determinant factors and it depends on the economic situation and the time span to which the economy is required to stabilize. In activist fiscal policy, it has been argued that the multiplier must be moderate and not unreasonably high and is generally dependent on the anticipated persistence of the stimulus determinant.

Short-term or temporary fiscal expansions are some much regarded as they do not cause private spending to crowd out. A three-year stimulus with regard to monetary accommodation will result in larger effects than a two-year expansion. This is because the increase in demand because of the multiplier results in higher inflation in the long-run thus resulting in a reduction in real interest rates.

The form of the fiscal multiplier is another determinant factor when choosing the suitable stimulus package as they impact demand through various channels. Government investment and consumption have direct impacts on the aggregate demand of an economy whereas reduction in tax and increase in transfer payments influences aggregate demand via their effects on disposable income. It is therefore considered that those that influences directly on the aggregate demand comprise of multipliers larger than those that do not impact directly but whose effects changes private spending. Government expenditure and consumption multipliers are approximately similar and are larger than those of taxes are and transferred.  

On fiscal policy, it can be concluded that fiscal policy has a role when it comes to rectifying economy’s instability because it can minimize social and economic cost in depression. In the events of large downturn, fiscal policy can be used to support monetary policy as long as it is set through a reasonable term framework to allow realization of the government’s long-term goals.

Due to financial crisis in the world over, it has made it appropriate for discretionary fiscal policy be a necessary policy response. This justification is due to the fact that fiscal response contributes more to economic growth than monetary policy especially with the downturns that does not involve severe financial crises.

Fiscal policy is used by Governments to manipulate the aggregate demand levels in an economy so as to realize its objectives. By increasing spending and cutting taxes to enhance aggregate demand, the government in the process is able to attain economy’s full employment, price stability and economic growth. These are the most crucial elements for economic stability, improvement of living standards and maximization of production.

Fiscal policy can be concluded to comprise of, taxes, public debts and government expenditure. These instruments can be used to manipulate the economy in the following; during inflation, government reduces its spending and increases taxes to reduce the buying power and to increase the money value. During deflation, government expenditure is increased and taxes cut. In general, fiscal policy tools are needed in the stabilization of the economy because it is a more responsive tool in times of financial crises and collapse of aggregate demand.

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