Fiscal policy is the use of government expenditure and revenue in order to influence the economy and fund public goods and services. Fiscal policy is the main instrument government uses in order to try and create economic growth. However its actual effectiveness at meeting this objective is arguably not that good for a number of reasons which will be discussed in this essay.
The main part of fiscal policy in order to increase growth is expansionary fiscal policy. This is where the government is spending more or cutting taxes in order to put more money into the economy than it is taking out. This is normally pursued when a government is trying to combat recession and increase economic growth. This should then shift aggregate demand to the right as shown in the diagram. This is because not only is increased government expenditure beneficial in the short run but also has a multiplier effect. This means that the money the government places in the economy multiplies as it spreads through the economy. This is because the spending creates more jobs which in turn create more money. This means that pursuing an expansionary policy is particularly effective at combating recession as not only does it boost economic growth but it also decreases unemployment, another important macroeconomic objective.
However that is only one part of an expansionary policy as it can also be combined with reduced taxation. This is also very effective at pushing economic growth as it gives more of an incentive to work as they get to keep more of their income. Not only would this increases productivity but again it would push aggregate demand to the right as people would have more expendable income to spend in the economy. This is also effective as the government may even get more money in tax revenue if it decreases tax due to the laffer curve. However these policies may not always be effective as people may want to save their money rather than spend it due to not feeling wealthy because of decreased confidence in the economy. During a recession this would almost definitely be the case among a lot of people therefore decreased taxation may not have the desired effect. People may also not find an incentive to work more as they may be content with earning more for the same amount of work. In fact they may be inclined to work less if they were suitably content with their previous income. Increased government expenditure may also not be as effective as it seems due to problems in the long term.
The government has to find money for the increased spending which would either come through increased taxation or borrowing which would lead to a budget deficit. As it is trying to promote economic growth it would most likely not come through taxation therefore the government would have to borrow. This would increase the national debt and interest payments would rise every year meaning that the government would either be forced to cut spending in the end anyway or borrow even more to meet these repayments thus getting caught in an endless circle. There is also the danger of the economy becoming “hooked” to government spending and any sudden withdrawal could lead to a major drop in economic growth. Therefore in the short term an expansionary fiscal policy is very effective at boosting economic growth but in the long term could have some very major negative effects.
This diagram shows the effects of an expansionary fiscal policy on aggregate demand. As you can see it shifts it to the right increasing demand in the economy which in turn boosts economic growth and the cash flow in the economy.
In conclusion fiscal policy is effective at promoting economic growth but only in the short run as in the long run it can have some very damaging effects on the economy. This is because the primary tool of fiscal policy to produce economic growth is cutting taxation and increasing government expenditure which can have a disastrous effect on public finances in the long run as the government is forced to borrow in order to pursue this policy. The only way to fix this problem would be to pursue a contractionary policy which would reduce economic growth so a government must be very careful with how much it puts in to the economy and for how long.
