The economy fluctuations in today’s world have become one of the most important factors in determining the direction of an economy growth. Non-stable economy can harm and slow the development and growing rate of a nation. There are many tools to stabilize the economy and reduce the frequency and the altitude of economic fluctuations. Among these tools are the fiscal policy and monetary policy. This report discusses the fiscal policy and why the governments use this too to stabilize the economy and encounter the economic fluctuations. Definition
Fiscal policy is a macroeconomic tool used by the government through the control of taxation and government spending in an effort to affect the business cycle and to achieve economic objectives of price stability, full employment and economic growth. By imposing taxes, the government receives revenue from the public which means the assets have been transferred from the public to the government. On the other hand, when the government spends money it transfers assets from itself to the public. So these two tools can be considered as opposite policies.
Types of Fiscal Policies
To explain the differences between the types of fiscal policies, the national income concept must be introduced. Then national income can be described by the following equation: Y=C+I+G+NX ................ (1)
Where Y is the national income, C is the consumption spending, I is the investment spending, G is the government spending, and NX is the net exports. This equation can be expanded to represent the taxes as follows: Y=C(Y-T)+ I+G+NX .............. (2)
Where C(Y – T) expresses that the consumption spending is based on both income and taxes. The disposable income refers to the money that can be spent on consumption after removing the taxes from the total income. Since the government has the control of taxation and its spending, changes in the level and composition of taxation and government spending can lead to two types of fiscal policies, expansionary fiscal policy and contractionary fiscal policy.
Expansionary fiscal policy:
This refers to the government policy that leads to an increase in the amount of money available for the population either by cutting some taxes or by increasing its purchases of goods and service, or by a combination of both. The expansionary fiscal policy is said to increase the total income when the economy is operating below its potential output or below the full-employment.
Contractionary fiscal policy:
This refers to the government policy that leads to a decrease in the amount of money available for the population either by imposing some taxes or by reducing its spending or by a combination of both. The contractionary fiscal policy is said to decrease the total income when the economy operates beyond its potential output, i.e. inflation occurred.
How do fiscal policies stabilize the economy?
In times of recession , when the economy operates under its full potential output the government tries to lower taxes in order to provide more disposable income for the public. In terms of the economy as a whole, this is represented in the output equation Y = C(Y - T) + I + G + NX, where a decrease in T, given a stable Y, leads to an increase in C, and ultimately to an increase in Y to its potential output. Increasing government spending has similar effects. When the government spends more on goods and services, the population, which provides those goods and services, receives more money. In terms of the economy as a whole, this is again represented by Y = C(Y - T) + I + G + NX, where an increase in G leads to an increase in Y to its potential output. Thus, expansionary fiscal policy makes the populace wealthier and increases output, or national income. So when there is a recession period where the total income is below its potential capacity and it operates under its full-employment level, the expansionary fiscal policy tends to move the...