5.2.2 How Fiscal Policy Affects Economy

How Fiscal Policy Affects The Economy

As we discussed in the previous chapter, gross domestic product (GDP) comprises three major components: government spending, consumer spending, and business spending and investment. Fiscal policy generally targets all three components. The government’s key fiscal policy tools are spending and taxation.

When the government announces a new budget, analysts scrutinize it closely. The budget reveals the government’s plans with respect to spending and taxation, and how our tax dollars are going to be used. It also acts as a crucial indicator of the government’s forecast for the economy in the next couple of years.

Key Economic Theories

Over the years, several theories have guided economic policy. Two prominent theories are Keynesian economics and the monetarist theory.

Keynesian Economics

Keynesian economics advocates direct government intervention to achieve economic growth and stability. This involves the use of fiscal policy to stabilize the economy. During a recession, the government may implement increased spending and lower taxes to stimulate economic activity. Conversely, during economic booms, it might pursue lower spending and higher taxes to control inflation.

Example:

• During a recession, the government could raise consumer income by increasing spending or lowering taxes. This increased income leads to higher consumer spending on goods and services.
• Businesses then expand production and hire more workers to meet the higher demand.
• The resulting decrease in unemployment further boosts consumer income and spending until economic policy shifts when spending rises too quickly.
• At this point, the government reduces spending and raises taxes.

Monetarist Theory

Monetarists argue against using fiscal policy to influence the economy, asserting that changes in the money supply cause economic fluctuations. Therefore, monetary policy, which involves control over the money supply and interest rates, should be the primary tool for managing economic stability and inflation.

Monetarist Approach:

• The central bank should expand the money supply at a rate equal to the economy’s long-term growth rate (e.g., 2%-3% per year).
• The main policy goal is to control inflation, setting a foundation for the economy to grow at its optimal rate.

Spending

Similar to businesses needing funds to operate, the federal government requires expenditure to run the country efficiently. This includes funding for utilities, salaries, programs, and investment in infrastructure projects. Governments can either increase spending to stimulate the economy or reduce it to manage inflation.

For instance, government funding for infrastructure projects, such as building a new highway, can increase GDP through several pathways. The project itself requires hiring workers and purchasing materials, which directly boosts government spending. The newly employed workers will then have more disposable income for consumer spending, further increasing business revenues and leading to more business investments.

Taxation

Government revenue largely comes from various taxes imposed on both businesses and consumers. Taxation policy is a potent tool that can either stimulate economic activity or manage inflation:

• To stimulate the economy: The government may lower personal taxes, leaving consumers with more money to spend. It can also reduce business taxes, providing firms with more capital for investment and expansion, leading to job creation and lower unemployment rates.
• To manage inflation: Increasing taxes can reduce disposable income for consumers and limit funds available for business expansion, thereby cooling off an overheating economy.

Economic Indicators

Persistent deficits in Canada during the 1980s led to increased borrowing and larger national debt, creating a cycle of growing deficits and debts. The debt-to-GDP ratio is a vital metric of a country’s overall debt burden, as it measures debt relative to the government and taxpayers’ ability to sustain it.

Here is an illustration of Canada’s federal debt as a percentage of GDP over time:

    graph TB
	    subgraph Debt-to-GDP Ratio
	        A1975[1975: 10%] --> A1980[1980: 15%]
	        A1980 --> A1985[1985: 30%]
	        A1985 --> A1990[1990: 45%]
	        A1990 --> A1995[1995: 60%]
	        A1995 --> B2000[2000: 55%]
	        A1995 --> C2010[2010: 40%]
	        C2010 --> D2015[2015: 35%]
	        D2015 --> E2020[2020: 30%]
	    end

Source: Annual Financial Report of the Government of Canada

Fiscal Policy Making Process

• Policymakers involved in fiscal policy include government officials, economists, and financial analysts.
• The process considers various economic indicators and theories to formulate policies that promote economic stability and growth.

Key Takeaways

• Fiscal Policy: Involves government spending and taxation to influence the economy.
• Keynesian Economics: Advocates direct intervention through fiscal policy to ensure economic growth and manage stability.
• Monetarist Theory: Suggests using monetary policy to control economic factors like the money supply and interest rates.
• Government Spending: Can stimulate the economy especially when directed toward infrastructure and development projects.
• Taxation: Acts as a tool to either stimulate economic growth or control inflation, depending on whether taxes are lowered or increased.

Glossary

• Fiscal Policy: Government strategies concerning expenditure and revenue collection to influence the economy.
• GDP (Gross Domestic Product): The total market value of all goods and services produced within a country in a given period.
• Keynesian Economics: An economic theory that advocates for direct government intervention to achieve economic growth and stability.
• Monetarist Theory: An economic theory that emphasizes the role of controlling the money supply to manage economic stability and inflation.
• Deficit: The amount by which government expenditures exceed revenue.
• Debt-to-GDP Ratio: A measure of a country’s federal debt in relation to its GDP, indicating the country’s ability to pay back debt.

Frequently Asked Questions (FAQs)

What Is the Primary Focus of Keynesian Economics?

Keynesian economics focuses primarily on government intervention to manage economic stability and growth via fiscal policy tools such as spending and taxation.

How Do Monetarists Suggest Controlling Economic Fluctuations?

Monetarists advocate using monetary policy, primarily through regulated adjustments in the money supply and interest rates, to control economic stability and inflation.

How Does Government Spending Stimulate the Economy?

Government spending, especially on infrastructure projects, can boost the GDP by creating jobs and increasing consumer and business spending.

What Happens When Taxes Are Lowered?

Lowering taxes increases disposable income for consumers and available capital for businesses, stimulating economic growth and potentially reducing unemployment.

Why Is the Debt-to-GDP Ratio Important?

The debt-to-GDP ratio provides insights into the sustainability of a country’s debt levels by comparing it with the capacity to generate revenue through economic activities.