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Introduction:

Fiscal policy is a government scheme that affects the economy through spending, taxes, and borrowing. Governments use fiscal policy to counter fluctuations in the business cycle by adjusting the level of government spending and tax rates on individuals and businesses. This policy is based on the Keynesian economic theory of British economist John Maynard Keynes. This theory describes aggregate demand as the government changes the level of taxes and the effect of government spending.

Table of contents:

• What is fiscal policy?
• How does fiscal policy works?
• Objectives of fiscal policy
• Tools of fiscal policy
• Types of fiscal policy
• Importance of fiscal policy
• Limitation of fiscal policy
• Differences between monetary and fiscal policy

 

• What is Fiscal Policy?

Fiscal policy is a government policy that uses taxes, government spending, and public debt to regulate the economy to achieve sustainable growth. Fiscal policy is part of the central bank's monetary policy. Fiscal policy is an important tool of macroeconomic management that is used to gain key objectives like controlling inflation, increasing economic growth, and reducing unemployment. 

• How does fiscal policy works?

Fiscal policy is a tax system designed to influence government spending and the economy in an expansionary or contractionary manner. In expansionary fiscal policy, the government raises spending or lowers taxes during a recession to boost demand, create jobs, and stimulate economic growth. On the other hand, in contractionary monetary policy, governments usually cut spending or raise taxes to reduce demand and control inflation during economic overheating.

• Objectives of Fiscal Policy:

The primary objectives of monetary policy are:

1. Economic Equilibrium: maintaining economic stability by controlling inflation and stimulating demand during periods of economic growth or recession.
2. Fiscal Growth: Allocation of funds to infrastructure, education, and other critical sectors to support long-term productivity growth and economic development.
3. Full employment: achieving and maintaining the unemployment rate by creating employment opportunities through government spending in various sectors.
4. Redistribution of income: Fiscal policy aims to support low-income groups through progressive taxation and implementing social welfare programs to reduce income inequality.
5. Controlling inflation: Fiscal policy aims to reduce demand by raising taxes or lowering government spending during times of inflation to cool an overheated economy.
6. Reduction of public debt: Fiscal policy seeks to manage public debt by balancing expenditure and revenue with the objective of ensuring long-term fiscal stability.

 

• Tools of Fiscal policy:

The components of fiscal policy are:

• Public spending on infrastructure, health care, education, and welfare programs stimulates economic growth by stimulating demand.
• Adjust income, corporate, and indirect taxes to affect consumer spending, business investment, and inflation.
• Governments issue bonds to finance spending without immediate tax increases, managing debt over time.
• Increases or decreases demand according to recession and good times.

 

• Types of Fiscal Policy:

The three main type of fiscal policy includes:

• Expansionary Fiscal Policy: It is used during a recession to increase government spending or cut taxes to stimulate economic growth, increase demand, and reduce unemployment.
• Contractionary fiscal policy: Used to reduce government spending or raise taxes to slow or control an overheated economy during inflation.
• Neutral Fiscal Policy: This policy is applied to maintain the current level of economic activity without aiming to stimulate or contract the economy, when government spending nearly equals revenue.

These policies help manage the economic cycle and achieve stability.

• Importance of Fiscal Policy:

Fiscal policy is an important tool of government to influence the economy of a country through spending and taxes. These policies are aimed at managing economic growth, controlling inflation, reducing unemployment, and stabilizing the economy for the business cycle. Expansionary fiscal policy is used during economic downturns to stimulate demand, increase employment, and encourage investment. Conversely, during deflation, contractionary fiscal policy helps to reduce demand and control price increases. Basically, fiscal policy is key to promoting sustainable economic growth and economic stability.

• Limitation of Fiscal Policy:

The limitations of fiscal policies are:

• Lag period: Addressing immediate economic challenges takes time to recognize economic problems, implement policy changes, and see results, which reduces its effectiveness.
• Political Constraints: Fiscal decisions often face political resistance if tax increases or government spending cuts are unpopular, leading to delays or ineffective policies.
• Crowding out: Large government borrowing to fund expenditure can lead to higher interest rates by reducing private investment. This phenomenon is known as "admission out."
• Risk of Inflation: Excessive government spending aimed at creating demand beyond productive capacity can lead to inflation.
• Accumulation of debt: High national debt resulting from persistent deficits and borrowing limits future fiscal flexibility.

 

• Differences between monetary and Fiscal Policy:

Differences between monetary policies and fiscal policies are:

No.	Subjects	Monetary policy	Fiscal policy
1	Definition	This is a policy managed by a country's central bank, to control the money supply and interest rates to influence economic activity.	This policy is controlled by the government, is used for making changes in government spending and taxation to manage the economy.
2	Tools	The primary tool of monetary policy includes interest rates, reserve requirements, and open market operations.	This includes government spending and taxation.
3	Responsibility	Central bank	Government
4	Goal	Achieving economic growth, stabilizing currency, and controlling inflation.	Creating jobs, managing economic cycles, and influencing demands.
5	Impact	It has no direct impact on govern debt.	It can regulate national debt based on taxation and government spending.
6	Time frame	Implementation is quicker but effects delayed.	Implementation takes time but effects immediately.

 

 

Conclusion:

Fiscal policy is an important tool for governments in managing economic stability and growth. It can affect aggregate demand by adjusting government spending and taxes, stimulating the economy during recessions, and relaxing the economy during inflation. While being effective in addressing economic challenges, fiscal policy also faces various constraints, such as political constraints, time lags, and potential debt accumulation. This policy, if used intelligently in coordination with other economic policies, is capable of promoting sustainable development and long-term economic health. 

FAQs:

1. Explain how inflation and deflation is controlled by central bank through monetary and Fiscal policy?

• Inflation Control: In monetary policy, the central bank raises interest rates, makes borrowing more expensive, and reduces the money supply to reduce demand and control inflation. While in monetary policy, the government helps lessen inflation by lowering demand or raising taxes to control demand.
• Inflation Control: In monetary policy, the central bank lowers interest rates, makes borrowing cheaper, and increases the money supply, thereby increasing demand and reducing inflation. On the other hand, in fiscal policy, the government increases spending or lowers taxes to stimulate demand and fight inflation.

2. How to correct inflationary gap and deflationary gap through monetary and Fiscal policy?

• Correction of an inflationary gap: central banks discourage borrowing and spending by raising interest rates to reduce the money supply through monetary policy. On the other hand, through fiscal policy, the government reduces spending or raises taxes to reduce demand and cool the economy.

• Correction of a deflationary gap: Central bank monetary policy increases the money supply by lowering interest rates, encouraging borrowing and spending. The government implicates fiscal policy for raising spending or cutting taxes in to stimulate the economy and increase demand.