Fiscal policy can be a very effective tool in achieving macroeconomic objectives, as it allows:
- Targeting of Specific Economic Sectors
- Direct Effect on Aggregate Demand
- Can Pull the Economy from Deep Recession
Targeting Specific Sectors
Fiscal policy can be precisely directed to address the specific economic needs set by the government:
- Infrastructure Projects: Government spending can be allocated to build roads, schools, or hospitals, boosting employment in construction and related industries.
- It can be focused on a variety of public goods as well, such as police forces, fire extinguishing forces, etc.
- Tax Incentives: Tax breaks can be offered to specific sectors, like renewable energy, to encourage investment and innovation.
Direct Effect on Aggregate Demand
- The changes in government spending (G), directly affect the aggregate demand (AD), causing a short time shift in AD in the desired direction.
- Fiscal policy can indirectly effect AD, through encouraging consumer spending(C) and investments(I) by e.g managing tax systems and rates.
- However, changes with respect to taxes are less direct and take a long time to shift the AD.
Ability to pull economy out of deep recession
- According to the Keynesian model, the wages on the way down are "sticky" (inflexible), hence the market forces alone may not be able to deal with the pressures of wages falling down.
- Therefore, fiscal policy can be used to stimulate growth in the aggregate demand and economic activity, hence addressing the recessionary gap.
Evaluating Fiscal Policy
Promoting Growth
- Short-Term Boost: Fiscal policy can quickly increase aggregate demand, reducing cyclical unemployment and stimulating growth.
- Long-Term Investment: Spending on infrastructure and education can enhance the economy productive capacity, increasing the potential output.
Achieving Low Unemployment
- Job Creation: Government projects can create jobs in targeted sectors.
- Increased aggregate demand due to expansionary fiscal policies increases the demand for labour, hence reducing cyclical unemployment.
- Investing in human capital, e.g skills, can decrease structural unemployment.
- Support for Incomes: Transfer payments maintain consumer spending during downturns.
Low and Stable Rate of Inflation
- Controlling Inflation: Contractionary fiscal policy can reduce aggregate demand and curb inflationary pressures.
- Avoiding Deflation: Expansionary policies can prevent deflation by boosting spending.
Automatic Stabilisers(HL Only)
Automatic Stabilizers
Factors without government interaction which automatically reduce the short-term business cycle fluctuations.
There are two main automatic stabilisers:
- Progressive Income Taxation
- Unemployment Benefits
Progressive Taxation
- During uprising in business cycle, where the incomes of individuals and businesses grow, these groups enter higher tax brackets, where they pay higher tax.
- Hence they have a lower disposable income. As a result, the expansion in aggregate demand is less than it would have been without progressive taxation.
- During falls in business cycle, where the incomes of individuals and businesses decrease, these groups enter lower tax brackets, where they pay lower tax
- Hence they have a higher disposable income. As a result, the fall in aggregate demand is less than it would have been without progressive taxation.
- This systems holds a great stability on economic activity.
Unemployment Benefits
- During recessions, when the unemployment increases and incomes decrease, the governments provide unemployment benefits to unemployed people.
- This act is performed so these individuals do not decrease their demand for goods/services, hence avoiding the AD in the economy to fall and cause any recession.
- During expansions, where unemployment decreases and incomes rise, governments reduce unemployment benefits:
- Therefore, the consumption grows slower than it would have grown with the presence of unemployment benefits.
- This system also helps keep the economic activity stable.
Progressive tax systems and unemployment benefits can only help reduce economic fluctuations, not stabilise and eliminate any gaps (recessionary or inflationary) in the economy.
Case studyConstraints on the Effectiveness of Fiscal Policy
Introduction
Governments worldwide use fiscal policy—taxation and government spending—to influence economic growth, employment, and inflation. However, the effectiveness of fiscal policy is often constrained by factors such as high public debt, time lags, political limitations, and crowding out of private investment. The cases of Japan, the United States, and Argentina highlight these challenges.
High Public Debt Levels: The Case of Japan
Japan has one of the highest public debt-to-GDP ratios in the world, reaching over 260% of GDP in 2023. Despite numerous stimulus packages aimed at boosting demand, Japan's economy has struggled with stagnation and deflationfor decades. The government’s ability to use fiscal policy is limited because additional spending increases debt levels, raising concerns about long-term fiscal sustainability. Investors continue to buy Japanese government bonds (JGBs)due to the country’s strong reputation, but if confidence declines, Japan may face higher borrowing costs.
Time Lags and Political Constraints: The United States
In the United States, fiscal policy decisions are often delayed by political gridlock. In 2023, disagreements between Republicans and Democrats over the federal debt ceiling nearly led to a government shutdown. Such delays in decision-making reduce the ability of fiscal policy to respond quickly to economic downturns. Additionally, implementation lags, such as the time required to pass stimulus bills and distribute funds, can mean that fiscal measures take effect too late to counteract recessions effectively.
The COVID-19 stimulus packages provide an example: while they boosted short-term demand, they also contributed to high inflation in 2021–2022, which required the Federal Reserve to tighten monetary policy. This demonstrates how poor fiscal timing can lead to unintended consequences.
Crowding Out of Private Investment: Argentina
In Argentina, persistent budget deficits and excessive public spending have led to high inflation (over 200% in 2023)and reliance on borrowing. As the government competes with businesses for available credit, interest rates rise, making it more expensive for private companies to invest. This effect, known as crowding out, slows economic growthand reduces the effectiveness of fiscal expansion.
In response to the crisis, the government of Javier Milei has attempted to cut spending, but political resistance and economic instability have made reforms difficult. This highlights how fiscal constraints can be worsened by politicaland structural issues.
Conclusion
While fiscal policy remains a powerful tool, its effectiveness is constrained by high debt levels, political conflicts, time lags, and the potential to crowd out private investment. The cases of Japan, the U.S., and Argentina illustrate the real-world challenges governments face in implementing effective fiscal policies.
Questions
- Explain how high public debt can limit the effectiveness of fiscal policy.
- Discuss the impact of time lags in the implementation of fiscal policy, using a real-world example.
- Evaluate the role of political factors in shaping fiscal policy decisions.
- Analyse how fiscal policy can contribute to inflation and what governments can do to balance economic growth with price stability.
- Assess the effectiveness of fiscal policy in developing economies compared to developed economies, considering constraints such as debt and political stability.
