UNIT3: FISCAL POLICY AND GOVERNMENT FINANCE

Welcome to unit three of this applied macroeconomics. In this unit, we will look at the nature of fiscal policy as a method of macroeconomic management.

SESSION 1: FISCAL POLICY, INFLATIONARY AND DEFLATIONARY GAPS 

Welcome to the first unit three session. We will examine the nature of fiscal policy as a method of macroeconomic management in this session.

Discretionary fiscal policy is referred to as deliberate modifications to government expenditure and tax rates with the goal of stabilizing the economy.

This session focuses on discretionary fiscal policy and its effects on inflationary and deflationary disparities.

Objectives At the conclusion of this session, participants must be able to

• recognize the meaning of government discretionary fiscal policy measures in an economy
• explain the inflationary gap and the deflationary gap in relation to fiscal policies

Now read on… 

Read also: UNIT2: SESSION 6: AGGREGATE DEMAND AND AGGREGATE SUPPLY

• Fiscal Policy

The concept of using fiscal policy to manage demand is primarily based on the work of British economist John Maynard Keynes in the 1930s. It involves manipulating taxation (personal and/or corporate) and government spending to influence the level of economic activity.

Keynes argued that demand-deficient unemployment resulted from a lack of aggregate demand and that market forces alone cannot generate enough jobs to eliminate this unemployment, especially in the short- to medium term. Utilizing discretionary fiscal policy to stimulate demand was his solution.

Economists use the term fiscal policy to refer to policies that affect government expenditure and taxation. It is concerned with decisions regarding the composition of government expenditures and taxation, as well as alterations to those levels.

Remember that an increase in government spending (G) is an injection into the circular flow of income, whereas taxation is referred to as a discharge from the circular flow of income. Therefore, an increase or decrease in either of these will affect aggregate demand and, consequently, national income. Can you provide an example?

• Fiscal Policy, Inflationary and Deflationary Gaps

In our previous meetings, we discussed how a deflationary gap represents a situation of demand deficiency in the economy, signifying the amount by which aggregate demand must be increased when the equilibrium level of national income is below its full employment potential.

To increase aggregate demand to the level required to raise national income and, consequently, short-run aggregate supply to the level of full employment, the government could either increase government spending or reduce tax rates. Due to the multiplier effect, either of these measures would result in an increase in demand that is multiplied.

In contrast, an inflationary gap represents a situation of excess demand in the economy and reflects the amount by which aggregate demand must be reduced in order to reach the equilibrium level of output with full employment and stable prices.

To close this gap, the government could either reduce spending or raise tax rates.

Again, these measures would reduce aggregate demand, this time via a negative multiplier effect. Remember that this has been discussed in previous sessions?

In Figure (a), expansionary fiscal measures (increase in government spending and reduction in taxation) lead to an increase in real GDP (national income) from Y1 to Yfe.

In Figure (b), contractionary fiscal measures (reduction in government spending and increase in taxation) result in a decline from AE3 to AE4 in the level of aggregate expenditure.

Note also that the required change in total expenditures is lesser than the resulting change in national income. The difference reflects the effect of the multiplier.

In this session, we examined the essence of discretionary fiscal policy and its application as a tool for countercyclical demand management.

Precisely, we concentrated on how fiscal policy can be used to bridge inflationary and deflationary gaps.

Self-Assessment Questions

Exercise 3.1

1. Explain government discretionary fiscal policy.
2. How does a discretionary fiscal policy result in a multiplier effect?
3. Explain with diagrams how government fiscal policies could result in an inflationary or deflationary gap.

UNIT2: SESSION 6: AGGREGATE DEMAND AND AGGREGATE SUPPLY

CONTINUE WITH SESSION: 2