Fiscal policy
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Fiscal Policy is the economic term which describes the behaviour of governments in raising money to fund current spending and investment for collective social purposes and for transfer payments to citizens and residents of the territory for which the government is responsible. The money may be raised by taxation, by borrowing, by user charges on social assets or services, or by fiat. (On the last, the government declares a particular token to be money and demanding that it be accepted in settlement of debts.) Fiscal policy can include deficit spending to stimulate demand for domestic goods and services to rise (to fight unemployment) or efforts to cut deficits or raise the budget surplus to fight inflation.
A government which wishes to borrow from foreign citizens will need to maintain accounts to allow potential creditors to assess its credit worthiness. These accounts are typically maintained on an annual basis giving rise to a fiscal year. In each fiscal year a government will have a total income (its revenue) and a total expenditure. The latter minus the former is the fiscal deficit (or fiscal surplus if negative). Year on year the fiscal deficit adds to (or reduces) outstanding government borrowing. If government debt (sometimes misleadingly called the "national" or "public" debt) is denominated in the government's own currency, then it will be devalued in line with the country's domestic inflation. Under crisis conditions a government may choose to default on (i.e., repudiate) its foreign (or more rarely) its domestic debt.
A government will pay interest on its outstanding debt. This must be paid out of tax revenue (or compensated for by cutting expenditures). For this reason a government will typically aim to ensure that its fiscal deficit averaged over the business cycle is no greater than the share of state spending of gross domestic product multiplied by the sustainable rate of growth of gross domestic product. An exception to this rule arises when the deficit finances government investment in infrastructure, public health, basic research, or education, which can stimulate increases in potential output, i.e., long-term (supply-side) economic growth.
The government's detailed decisions in this arena form its fiscal policy.
Types
Given different situations, the government may adopt certain policies that can either increase or decrease output in the short run. For instance, if the government faces a threat of a recession, it may adopt an expansionary fiscal policy, a policy that involves increasing government spending and cutting taxes, in order to spur economic output. Conversely, the government may adopt a contractionary fiscal policy, involving a reduction in government spending and an increase in taxes when faced with an overheating economy. These actions, however, may have other effects in the economy. For instance, an expansionary fiscal policy may lead to the crowding out of investment.
Contractionary fiscal policy is a deliberate change in government spending or taxes in order to slow the economy (to prevent inflation). It may fight inflation, decrease trade deficit, and make interest rates fall to stimulate the economy in the long run.
The United States government prefers to use contractionary fiscal policy as few times as possible, and relies much more heavily on contractionary monetary policy to combat inflation. The reason for this is that monetary policy is run by the Federal Reserve Board, which does not have to deal with politics. The United States Congress and President, however, will generally only be concerned with short-run economic effects. This is because the President will not care how many times the economy grows in (say) 10 years as s/he wants people to vote for him/her in four years. In the short run, contractionary fiscal policy may increase unemployment, risk recession, slow output growth, and cause various political problems. Also, fiscal policy (whether expansionary or contractionary) assumes things that are not necessarily true in real life: like that the government can change taxes almost instantaneously or that the government knows the exact extent of (in the case of contractionary fiscal policy) inflation. To quote the textbook Economics, by Professor Colander, "fiscal policy is a sledge hammer, not an instrument for fine tuning. When the economy goes into a depression, the appropriate fiscal policy is clear. Similarly when the economy has hyperinflation, the appropriate policy is clear..." However, in between, a good mix of contractionary monetary policy and contractionary fiscal policy can keep inflation in check.