This greater demand leads to increases in both output and prices. The first impact of a fiscal expansion is to raise the demand for goods and services. This effect of fiscal policy was central to discussions of the "twin deficits" (budget and trade) of the eighties.įiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output produced-that is, gross domestic product. Foreigners sell more to the country than they buy from it, and in return acquire ownership of assets in the country. This appreciation makes imported goods cheaper in the United States and exports more expensive abroad, leading to a decline of the trade balance. Foreigners bid up the price of the dollar in order to get more of them to invest, causing an exchange rate appreciation. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In an open economy, fiscal policy also affects the exchange rate and the trade balance. Thus, expansionary fiscal policy reduces the fraction of output that is used for private investment. In doing so, it competes with private borrowers for money lent by savers, raising interest rates and "crowding out" some private investment.
When the government runs a deficit, it meets some of its expenses by issuing bonds. This rise in consumption will, in turn, raise aggregate demand.įiscal policy also changes the composition of aggregate demand. Second, if the government cuts taxes or increases transfer payments, people's disposable income rises, and they will spend more on consumption. First, if the government increases purchases but keeps taxes the same, it increases demand directly. A fiscal expansion, for example, raises aggregate demand through one of two channels. The most immediate impact of fiscal policy is to change the aggregate demand for goods and services. Thus, a reduction of the deficit from $200 billion to $100 billion is said to be contractionary fiscal policy, even though the budget is still in deficit. Often the focus is not on the level of the deficit, but on the change in the deficit. Fiscal policy is said to be tight or contractionary when revenue is higher than spending (the government budget is in surplus) and loose or expansionary when spending is higher than revenue (the budget is in deficit). The state of fiscal policy is usually summarized by looking at the difference between what the government pays out and what it takes in-that is, the government deficit. Discussions of fiscal policy, however, usually focus on the effect of changes in the government budget on the overall economy-on such macroeconomic variables as GNP and unemployment and inflation. The primary economic impact of any change in the government budget is felt by particular groups-a tax cut for families with children, for example, raises the disposable income of such families. When the government decides on the taxes that it collects, the transfer payments it gives out, or the goods and services that it purchases, it is engaging in fiscal policy. Some government spending also acts as an automatic stabilizer.Fiscal policy is the use of the government budget to affect an economy. This automatic tax cut stimulates aggregate demand and, thereby, reduces the magnitude of economic fluctuations. the corporate income tax depends on firm’s profits.īecause incomes, earnings, and profits all fall in a recession, the government’s tax revenue falls as well.
the payroll tax depends on workers’ earnings, and.The personal income tax depends on household’s incomes,.Meaning of Finance & Financial Structures.Strategies for Increasing Customer Value.Management Accountants in Organizations.Trade-Offs in Using Accounting for Multiple Purposes.Epistemology: Human's Capacity to Retain Knowledge.Interdependencies in Multi-Value System.How Fiscal Policy Influences Aggregate Demand.The Liquidity Preference Theory's Implications for Aggregate Demand.Why the Short-Run Aggregate-Supply Curve Might Shift.Why the Aggregate-Supply Curve Might Shift.Why the Aggregate-Demand Curve Might Shift.Explanations for Short-Run Economic Fluctuations.Three Key Facts About Economic Fluctuations.Education's Importance to Economic Growth.Small Differences in Growth Rates Matter.Economic Growth Rate & Formula to Calculate It.How Else Can We Measure Economic Wellbeing?.Shortcomings in GDP as a Measure of Wellbeing.Shortcomings in GDP as a Measure of Total Production.Forming and Testing Hypothesis in Economic Models.Story of the Market System in Action: I, Pencil.Centrally Planned Economies versus Market Economies.The What, How, and Who Economic Questions.
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