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The effectiveness of fiscal policy in achieving the economic growth.

Key terms:

  • Fiscal policy is a demand-side policy using changes in government spending and/or direct taxation to influence aggregate demand and thus growth, employment and prices.

  • Economic growth refers to increases in real GDP over time.

  • The crowding out effect is an economic theory that argues that rising public sector spending drives down or even eliminates private sector spending.


Diagram 1:

The diagram above illustrates the economy of the U.S. in 2009, where the U.S. government implemented fiscal policy in order to drive the increase in aggregate demand, namely by passing a stimulus package that included a mix of tax cuts, infrastructure spending. Initially, the economy is at the point of intersection PL1, Y1 in the deflationary gap. The government, then, introduces fiscal policy in the form of reducing personal income tax and increasing government spending. The reduction in personal income tax leads to increase in the disposable income of households, which in turn, increases their purchasing power, thus their consumer spendings are likely to increase, leading to a rightward shift of the AD curve because consumer spendings is a part of the AD formula C+I+G+(X-M). Meanwhile, the increase in government spendings also adds up to the increase in the aggregate demand since it is also a part of the AD formula, where G stands for increased government spendings. But, in addition, increased government spendings might include spendings on public goods, including education and training for workers, thus it might increase the labor productivity, and hence the output, which leads to economic growth, or increase in real output. Therefore, the fiscal policy shifts the AD curve to the right from AD2 to AD1, allowing it to approach the natural rate of unemployment at Yp and Pl2. Fiscal policy has several advantages and disadvantages in terms of reaching economic growth.

Diagram 2:

Firstly, the feature of crowding out serves as a barrier for the effectiveness of the fiscal policy because when a government carries out expansionary fiscal policy, it needs to borrow to pay for increased government expenditures, which increase interest rates. This leads to lower investment and consumption spending due to the higher cost of borrowing, which to a some extent reduces the effect of expansionary fiscal policy, thus leading to decrease in AD, as shown on diagram 2: the AD1 first shifts to AD2 due to increase in government spending, then shifts leftwards from AD2 to AD2 due to decreased consumption and investment. Furthermore, there are some political constraints because cuts in taxes and increases in government spending may be undertaken for political reasons since households favour such changes due to increase in their wealth factor, yet, since the reasons are not economic, necessary policies may be avoided, which might lead to decrease in the aggregate demand and reduce economic growth. On the other hand, fiscal policy is effective in the way that government spending has a direct impact on aggregate demand when compared to tax cuts, thus directly influencing economic growth, since in case of the tax reductions, a tax cut to encourage spending may result in higher savings in the event of low consumer confidence as in the example of the U.S. provided, due to the preliminary Great Recession. Moreover, expansionary fiscal policy might lead to increase in potential output, or LRAS, might increase their spendings to pursue interventionist supply-side policies in the form of trainings for workers, thus it would not only improve the labor quality and labor productivity, but also might result in decrease in the natural rate of unemployment by reducing the structural unemployment since workers might be trained for changes in the structure of the economy, for example, move to technical industries.

In the short-run, fiscal policy works with major time lags, involving delays in making decisions and implementing the policies required to make tax cuts, as well as borrowing in order to proceed with government spendings, but also it takes time for the effects to be felt, thus it is not effective in the short-run. In the long-run, fiscal policy is likely to be effective in causing economic growth since the tax cuts would encourage consumers to spend more due to increase in the wealth factor because of the increased disposable income, and hence purchasing power, just as it would enable time to improve consumer confidence.

Furthermore, there are alternative solutions as expansionary monetary policy, which involves decrease in the interest rates to boost consumption and investment. The advantages of monetary policy in comparison to fiscal policy are that there are no political constraints as the central bank is independent of the government, and monetary policy does not involve the government spendings. Moreover, it could be implemented in a stepwise approach, thus fine-tuning the policy by adjusting the interest rates, and this would help prevent abrupt upturns, or downturns in the business cycle. Yet, there are some time lags, though shorter, due to time required to implement the policy, namely decrease the interest rates through increasing the money supply with the help of, for example, bond-buying which involves purchasing of the issued bonds by central bank, thus increasing the amount of money in the market, and decreasing the interest rate.

In conclusion, despite the disadvantages of the policy as crowding out, political constraints and alternative solutions as monetary policy, it is effective in promoting economic growth and increasing real output due to long-run effectiveness in increasing consumption, potential increase in the potential output and its direct effect on the AD.

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