Fiscal Policy Demystified!

Fiscal policy may broadly be defined as the governmental policy that influences the economy via the tools of taxation and government spending. By utilizing the various tools of fiscal policy, governments can affect economic activity, aggregate demand, resource allocation and income distribution. Though the impact of the fiscal policy may seem similar to that of monetary policy, the two are distinctly different in the tools they employ. Fiscal policies being pursued by governments can be of three types, neutral, contractionary and expansionary.  

Neutral fiscal policy
The fiscal policy is termed to be neutral, when the government spending equals tax collections and is associated with a balanced budget. In theory, a neutral fiscal policy does not have any impact on the level of economic activity.

Expansionary fiscal policy
The fiscal policy is said to be expansionary when the government spending exceeds tax collections. Such policy is usually associated with fiscal deficits and is implemented to accelerate aggregate demand in the economy.

Contractionary fiscal policy
A contractionary fiscal policy is the result of government spending being less than tax revenues and is usually associated with a budget surplus. Governments implement contractionary fiscal policies to reduce aggregate demand in the economy.

Objectives of fiscal policy
The objectives of fiscal policy are somewhat similar to that of monetary policy. Via the use of fiscal policy, governments impact the level of aggregate demand in the economy to achieve the objectives of price stability, full employment and economic growth.

Fiscal policy gained popularity in the 1930s after it was propounded by the British economist Lord Keynes. Keynes suggested that in times of recession, putting more money in the hands of the people could stimulate economic growth. This could be done via reducing taxes or increasing government spending. This could be done even if the government had to spend more than it collected via tax receipts and thereby sustain a budget deficit. Once the economy got recharged, government spending could be reduced and tax collections upped to balance the deficit.

According to the Keynesian theory, an overheated economy could be cooled down by reducing government spending or increasing tax collections, thereby reducing money in the economy. Reduction of money in the economy would lead to a reduction in aggregate demand and bring about price stability.

Financing of fiscal deficits and impact on exchange rates
The budget deficit resulting from an expansionary fiscal policy needs to be financed. This can be done via printing of fresh currency, public borrowing or over seas borrowing. Each one of these methods has a different impact on the economy.

Printing of fresh currency is a tool which is similar to the monetary policy tool of increasing liquidity in the economy. However, the way the money reaches the economy is different in both cases. In both cases, since this is new money, which is being inducted into the economy, it can prove to be inflationary and can have a downward impact on interest rates. This obviously would lead to depreciation in the value of the domestic currency vis-à-vis other currencies.

Public borrowing or issuance of public debt leads to government paper being sold to the public. This leads to a reduction in the money in the economy, which is then spent by the government. This method of financing the fiscal deficit can lead an increase in the interest rate in the economy and also leave less money for investment by the private sector. This is often termed as the crowding out of private sector investment. Intuitively, this implies a reallocation of resources in the economy as the government may choose to spend it on public projects like construction of roads or dams, whereas the private sector could have spent it on consumer led projects. In any case, an increase in interest rates would attract foreign investment in government paper and is likely to lead to an appreciation in the local currency.

The impact of funding a fiscal deficit via foreign borrowing would lead to monetary expansion as money form outside the system is entering it. This is likely to have a softening impact on interest rates leading to depreciation in the local currency. However, the inflow of foreign currency being used to finance the fiscal deficit is likely to pressurize the local currency to move upwards. Thus the immediate net affect of financing a fiscal deficit via foreign borrowing may be balanced out as substantiated above and may not lead to a major change in the value of the local currency.

Fiscal policy in the US

The Great Depression and the ensuing period created the fertile opportunity for fiscal policy to be put to test. Though Keynesian view points were not fully accepted in the early 1930s, the massive military spending associated with World War II seemed to support his theory. The enhanced government spending of this period raised income levels, brought factories to full capacity and the great depression became history.

While such policy performed well till the 60s, government and consumer overspending beyond this period proved inflationary and then the US was hit by the oil crisis in the early 70s. Rising oil prices fueled cost-push inflation. The traditional fiscal policy tool of increasing taxes to reduce liquidity seemed to fail in this scenario as it would lower money at the hands of people, whose incomes were already hit due to higher oil prices and inflation. Reducing money in the hands of people by cutting taxes would have dampened demand even further and led the economy into a recession. This was followed by an era of stagflation for which Jimmy Carter’s fiscal package also failed.

Towards the later years of the 20th century, management of the economy via the fiscal policy gave way to the adoption of the monetary policy. One of the key reasons for the adoption of the monetary policy as a key tool for managing the economy was that fiscal deficits led to public borrowing, which raised interest rates in the economy and crowded out private investment. Thus, the very goal of fiscal policy to provide fiscal stimulus was being lost. The adoption of monetary policy also signaled a reduction in the role of the state in managing the economy, with monetary policy focusing on broader goals like keeping inflation low and maintaining a stable economic cycle, while the private sector decided where to invest. This is considered as a shift to a greater form of capitalism, where resource allocation is left to market forces and not influenced by the government.

A shift from the usage of fiscal policy to monetary policy for managing the economy also means that the former’s impact on exchange rates is reserved, though an eye needs to be kept on the fiscal deficit. Any undue growth in the fiscal deficit is likely to have an adverse impact on the dollar’s value and vice versa. This may get more pronounced if the deficit does not come under control for a prolonged period of time.