Fiscal policy
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Fiscal policy is the economic term which describes the actions of a government in setting the level of public expenditure and how that expenditure is funded.
It contrasts with monetary policy, which describes the policies about the supply of money to the economy.
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Methods of raising funds
Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits.
This expenditure can be funded in a number of different ways:
- Taxation of the population
- Seignorage, the benefit from printing money
- Borrowing money from the population, resulting in a fiscal deficit.
Funding of deficits
A fiscal deficit is often funded by issuing bonds, like Treasury bills or consols. These pay interest, either for a fixed period or indefinitely. If the interest and capital repayments are too great, a nation may default on its debts, most usually to foreign debtors.
Economic effects of fiscal policy
Governments often use their fiscal policy to try to influence the economy towards economic objectives such as low inflation and unemployment.
According to Keynesian economics, high government spending, funded by a deficit, can be beneficial to the economy by stimulating aggregate demand and decreasing unemployment, during a recession.
A corollary of this is that, during a period of inflation, a reduced deficit (or a budget surplus), can reduce inflation by reducing aggregate demand. This is a result of the Phillips curve, which describes the link between inflation and output/unemployment.
The nature of fiscal policy has other economic effects, which are emphasised by other schools of economic thought. In particular:
- government borrowing is held to reduce private-sector borrowing and investment because of crowding out.
- the linkage between deficits and inflation via the Phillips curve is controversial
- Ricardian equivalence suggests that, since any fiscal deficit must ultimately be repaid, government borrowing will not affect the economy.
All these factors suggest that the long-run effect of borrowing is much less beneficial than the short-run effect. To stop governments over-borrowing to meet short-term objectives, some nations have adopted fiscal policy rules, like the Golden Rule and the Stability and Growth Pact.
Monetary effects of fiscal policy
The fiscal policy of a government can affect the monetary policy. Government borrowing competes for the same loanable funds as other investment, so an increased deficit may result in a rise in interest rates. Government debt also represents a form of money on the broad definition, increasing the money supply.
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