31 August 2012

Day 84: Fiscal Policy and the Budget

So - what tools does the government have available to intervene in the economy?

These tools are:
- Government spending
- Taxation
- Borrowing

Every government specifies how they will make use of these tools in the budget. So - the budget will reflect a government's policy in terms of what types of results they wish to achieve and how they will practically do that. The main points that are given attention within the budget are government spending and taxation. For instance, the government will specify how much funds will be available for education, for healthcare, for military training, etc. - as well as what types of products will be taxed, by how much and how incomes will be taxed. Looking at a government's budget will give you an idea of what the government deems to be important and what not. The budget is in essence a plan in terms of how the government wishes to regulate the demand and supply for goods and services in the economy.

We have already discussed monetary policy extensively in previous blog-posts. The budget and all the tools a government has available are referred to as 'fiscal policy' ('fiscal' comes from the word 'fiscus', which is what the public treasury was called in ancient Rome). Monetary policy - as carried out by the central bank - and fiscal policy are attempted to be carried out in harmony to prevent the one policy from counteracting the other one.

In this blog-post we'll introduce you to the 'general idea' of how governments utilise the tools of government spending, taxation and borrowing - after which we'll discuss each point individually.

What will a government generally do when the economy is in a recession?

Firstly - what is a 'recession'? Recession is when the economy is doing 'bad'. Compare the economy to the human body - where exchanges take place, blood flows, organs interact with each other and each cell has certain requirements in terms of the sustenance that it requires in order to function properly. A recession is when the economy is 'ill' - where fluids don't move through the body effectively and resources/sustenance are not reaching the participating cells in an effective way. Signs of a recession are a fall in income, total production, investment spending, business profits and inflation - and a rise in unemployment and bankruptcy.

So - with the understanding of the word 'recession', we ask the same question again: What will a government generally do when the economy is in a recession?

When in a recession, the government will pursue 'expansionary' fiscal policies so as to stimulate economic activity. 'Expansionary fiscal policy' can be translated into: an increase in government spending and a reduction in taxes. Increasing government spending and reducing taxes are both policies to increase the money supply - eg: increase the amount of money in circulation in the economy.

When applying expansionary fiscal policy, a budget deficit is usually created - because governments increase what they spend, and decrease what they earn. The difference between what is spent and what is earned (the difference between what goes out in the form of government spending and what comes in in the form of taxes) is called the 'budget deficit'.

The opposite can also occur - when an economy, instead of being in a recession, is expanding too quickly. In those cases, all prices will rise (inflation) and industries in other countries will become more competitive in comparision, leading to balance of payment problems (where more money leaves the country than comes into the country). In such a situation, the government will attempt to pursue 'restrictive' or 'contractionary' fiscal policy. This can be translated into: a reduction in government spending and a raise in taxes. The idea here is to withdraw money out of circulation.

This all sounds really neat and simple - but in practicality, it's not that clear-cut. The problem is that there is usually quite a big delay between what happens in the economy (for instance a recession) and the response of the government (for isntance expansionary policy). Sometimes - by the time the government is aware of the recession and starts implementing expansionary policies, the economy may have already started expanding by itself and the governments' measures are pointless, or even make matters worse.


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