In economics and political science, fiscal policy is using a government revenue collection mainly by taxes and the expenditure of it, which influences the economy. When the government changes the level of taxation and government spending it influences aggregate demand and the level of economic activity. Fiscal policy can be used to stabilize the economy over the course of a business cycle. The two main instruments are changes in the level, composition of taxation, and government spending in various sectors. The other changes can affect the macroeconomic variables such as aggregate demand and the level of economic activity; savings and investment in the economy, and the distribution of income.
Fiscal policy is distinguished from monetary policy in that it deals with taxation in government spending and is often administered by an executive under laws of legislature. Money policy deals with the money supply, lending rates and interest rates it is often administered by a central bank.
There are three main stances of fiscal policy. Neutral fiscal policy is undertaken when an economy is in equilibrium. Government spending is fully funded by tax revenue and the budget outcome has a neutral effect on economic activity. Expansionary fiscal policy involves government spending exceeding tax revenue and is undertaken during recessions. Contractionary fiscal policy occurs when government spending is lower than tax revenue and it pays down government debt. These definitions can be misleading because even with no changes in spending or tax laws, cyclic fluctuations of government cause cyclic fluctuations of tax revenues. Therefore, for purposes of the above definitions, government spending and tax revenue are normally replaced by cyclically adjusted government spending and adjusted tax revenue. For example a government budget that is balanced over the course of business cycle is considered to represent a neutral fiscal policy stance.
Governments spend money in a wide variety of things from the military to police education, healthcare as well as transfer payment such as welfare benefits these expenditures are funded in a variety of ways including taxation, printing money, borrowing money from the population or abroad, consumption of fiscal reserves and sale of fixed assets.
Borrowing involves a fiscal deficit funded by issuing bonds; treasury bills consols or guilt edged securities. These pay interest for a fix time or indefinitely. If the interest is too large a nation may default on its debts usually to foreign creditors. Public debt or borrowing refers to the government borrowing from the public.
Consuming prior surpluses - is a fiscal surplus save for future use and may be invested in local currency or any financial instrument. For this to happen, the marginal propensity to save needs to be strictly positive. Another possibility is the government might decide to increase its own spending by building highways. The idea is that the additional government spending creates jobs and lowers the unemployment rate.
Governments use fiscal policy to influence the level of aggregate demand in the economy, in an effort to achieve economic objectives of price stability, full employment, and economic growth. Keynesian economics suggested increasing government spending and decreasing tax rates are the best ways to stimulate aggregate demand, and decreasing spending and increasing taxes after the economic boom begins. It is argued this method is used in times of recession or low economic activity as a tool for building the framework for strong economic growth.
Governments can use a budget surplus to do two things, to slow the pace of strong economic growth and to stabilize prices when inflation is too high. Keynesian theory says that removing spending from the economy will reduce levels of aggregate demand and contract the economy the stapling prices. Economists still debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out: when government borrowing leads to higher interest rates that offsets the simulative impact of spending. When the government runs a budget deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This causes a lower aggregate demand for goods and services contrary to the object of a fiscal stimulus. Economists emphasize the fiscal policy can still be effective especially in a liquidity trap where they argue crowding is minimal.
Crowding out completely negates any fiscal stimulus and this is known as the treasury view. The Treasury View refers to theoretical positions of classical economists. The classical view, expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. One government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand causes that countries’ currency to appreciate. Once a currency appreciates, goods originate from that country now costs more to foreigners and they did before and foreign goods now cost less. Consequently exports decrease imports increase.
Some economists oppose the discretionary use of fiscal stimulus because of the inside lag which is almost inevitably long because of this substantial legislative effort involved. The outside lag between the time of implementation and the time that most of the effects of the stimulus are felt could mean that the stimulus hits an already recovering economy and exacerbates the ensuing boom rather than stimulating the economy when it needs it.
The concept of fiscal straitjacket is a general economic principle that suggests strict constraints on government spending and public sector borrowing to limit or regulate the budget deficit over time period. Most US states have balanced budget rules and prevent them from running a deficit. The United States federal government technically has a legal cap on the total amount of money you can borrow, but is not a meaningful constraint because the cap can be raises easily as spending can be authorized, and the cap is always raise before the debt gets that high.