Fiscal Policy

Note on Fiscal Policy

What is Fiscal Policy?

The government’s handling of its own spending, taxation and government borrowing are the key components of fiscal policy. Fiscal policy involves the use of government spending, taxation and borrowing to influence both the pattern of economic activity and also the level and growth of aggregate demand, output and employment. A rise in government expenditure, or a fall in the burden of taxation, should increase aggregate demand and boost employment. The size of the resulting final change in equilibrium national income is determined by the multiplier effect. The larger the national income multiplier, the greater the change in national income will be.

However fiscal policy is also used to influence the supply-side performance of the economy. For example, changes in fiscal policy can affect competitive conditions individual markets and industries and change the incentives for people to look for work and for companies to invest and engages in research and development. Government capital spending on transport infrastructure and public sector investment in education and health can also have a direct but unpredictable effect in the long run on the competitiveness and costs of businesses in every industry.

Government Spending- Government spending can be broken down into three main categories:

 General government expenditure - consists of the combined capital and current spending of central government including debt interest payments to holders of government debt

 General government final consumption - is government expenditure on current goods and services excluding transfer payments

 Transfer payments – transfers are transfers from taxpayers to benefit recipients through the working of the social security system.

In other words, fiscal policy refers to the policy of the government with regard to taxation, public expenditure and public borrowings.

The importance of fiscal policy is high in underdeveloped...