Fiscal Policy: An Introduction | CFA Level I Economics

In this lesson, we will learn the roles and objectives of fiscal policy, how to determine if a fiscal policy is expansionary or contractionary, and some of the limitations of fiscal policy.

Understanding Fiscal Policy

Fiscal policy refers to a government’s use of spending and taxation to meet macroeconomic goals. In contrast, we’ve learned that monetary policy is the responsibility of the central banks which uses tools like policy rate and reserve requirements to adjust the money supply.

While the central bank’s primary objective is to maintain price stability and should ideally be independent from government interference, fiscal policy is the responsibility of the government, and the primary goal is economic stability.

Besides this main objective, fiscal policy can also be a means to:

• Redistribute wealth and income among segments of the population
• Allocate resources among sectors in the economy

Keynesian economists believe that fiscal policy can have a strong effect on economic growth when the economy is operating at less than full employment. They argue that for long and deep recessions, government intervention in the form of expansionary fiscal policy is necessary to save the economy.

Monetarists, on the other hand, believe that the effect of fiscal stimulus is only temporary. Rather, they believe money supply has the greatest effect on the economy, and that monetary policy should be steady and predictable in order to maintain price stability.

Government Budget, Surplus, and Deficit

A government budget is the tax revenue minus the government spending. It is said to be balanced when tax revenues equal government spending. A budget surplus occurs when government tax revenues exceed spending, and a budget deficit occurs when spending exceeds tax revenues.

In general, lower taxes and higher government spending both increase a budget deficit. This has the effect of increasing aggregate demand, economic growth, and employment.

Conversely, higher taxes and lower government spending both increase a budget surplus. Aggregate demand, economic growth, and employment usually decrease when this happens.

It is important to note that running a budget surplus does not necessarily mean the fiscal policy is contractionary, nor does a budget deficit mean the fiscal policy is expansionary. Rather, economists often focus on the change in the surplus or deficit to determine if the fiscal policy is expansionary or contractionary. An increase in surplus is indicative of a contractionary fiscal policy. Similarly, an increase in deficit is indicative of an expansionary fiscal policy.

Structural Budget Deficit and Fiscal Policy

Economists often use a measure called the structural budget deficit to gauge fiscal policy. This is the deficit that would occur based on current policies if the economy were at full employment.

Let’s say an economy’s structural deficit is estimated to be at a certain level. If the actual budget runs at this level, it can be said that the fiscal policy is neutral.

However, if the economy slows and unemployment rises, taxes collected will decrease because of lower income earned, and unemployment payouts will increase, both of which increase the budget deficit. Notice that even without any government intervention, the fiscal position is automatically expansionary. We call these automatic stabilizers, which are built-in fiscal devices triggered by the state of the economy.

If the government intentionally seeks to further increase the deficit by increasing spending on infrastructure projects, and lowering the tax rate to increase aggregate demand and counter the economic slowdown, we call this discretionary fiscal policy.

Similarly, during boom times, higher tax revenues coupled with lower payouts for social programs tend to decrease budget deficits and are contractionary. These are automatic stabilizers that prevent the economy from overheating. If the government takes additional steps to cool demand by raising tax rates and curb spending, it is discretionary fiscal policy.

Lags and Limitations of Fiscal Policy

The main criticism regarding discretionary fiscal policy is that complications arise in practice that delay its implementation and impact on the economy. The lag between recessionary or inflationary conditions in the economy and the impact on the economy of fiscal policy changes can be divided into three stages:

1. Recognition lag: The state of the economy is complex, so it may take time for policymakers to recognize the nature and extent of the economic problems.
2. Action lag: This is the time the government takes to discuss, vote on, and implement fiscal policy changes.
3. Impact lag: This is the time between the implementation of fiscal policy changes and when the impact of the changes on the economy actually takes place. It takes time for corporations and individuals to act on the fiscal policy changes, and fiscal multiplier effects take time to propagate as well. We’ll learn what the fiscal multiplier is in the next lesson.

These lags can actually make fiscal policy counterproductive. For example, if policymakers identify that the economy is in a recession, and they subsequently implement expansionary fiscal policy to counter it. However, by the time the policy has its full impact, the economy may already be on a path to recovery, and the expansionary policy may aggravate inflationary pressures on the economy.

Besides this, some other limitations of fiscal policy include:

• Misreading economic statistics: Forecasting models can sometimes give misleading results. Policymakers can be misled and apply the inappropriate fiscal policy to the economy. For example, if policymakers think that the economy is below full employment when it actually is above, applying expansionary fiscal policy will increase inflationary pressure.
• Limit to expansionary fiscal policy: If the markets perceive that the government’s budget deficit is already too high, funding the deficit will be problematic. This could lead to higher interest rates, which could lead to lower demand and consumption in the economy.
• Crowding-out effect: If the government borrows heavily to fund its expansionary fiscal policies, the cost of borrowing may rise, and the private sector may cut back on investments.
• Resource constraints: If economic activity is slow due to resource constraints like labor shortage and not due to low demand, expansionary fiscal policy will have limited effect as production cannot increase. Rather, this will probably lead to higher inflation.
• Stagflation: If the economy has high unemployment coupled with high inflation, fiscal policy cannot address both problems simultaneously. High unemployment requires expansionary policy to counter, while high inflation requires contractionary policy to counter.

And that concludes our introduction to fiscal policy. We will continue in the next lesson by learning some of the fiscal policy tools and calculating the effect of fiscal policy on the economy.