Pros and Cons of Using Expansionary and Contractionary Fiscal Policy

After the stock market crash and the start of the Great Depression, that view changed. The advantages of fiscal policy proactively preventing economic collapse began to look better than nonintervention. Businesses like a certain amount of long-term security available to them when contemplating significant financial decisions. If there is the threat of an increase in the interest rate, then a company might decide to stall on their decision to expand operations. Should this occur, then the result would be less production, higher prices, and less consumer access to the goods or services created. Some customers would stop buying items because they could no longer afford what they want.

In the United States, the national fiscal policy is determined by the executive and legislative branches of the government. Monetary policy refers to central bank activities that are directed toward influencing the quantity of money and credit in an economy. By contrast, fiscal policy refers to the government’s decisions about taxation and spending.

  1. Government spending is fully funded by taxes collected; therefore, government spending equals taxation.
  2. His results suggest that crowding out depends on the nature of spending done by the government.
  3. This kind of policy is set when the government is spending more than the taxes collected.
  4. The economic decisions of households can have a significant impact on an economy.

In order to reduce such a lag and to minimize the legislative and executive red-taps, it is important to keep a shelf of public works in readiness. The recognition and administrative lags together determine the inside lag of the fiscal policy and its length, according to Willes, is 4 to 18 months. However, despite the increase in the money supply, the ongoing credit crunch caused banks to save the newly created money, and the effect on increasing growth was limited. In addition to cuts in interest rates, another tool of monetary policy is to pursue quantitative easing.

Contractionary vs. Expansionary Monetary Policy

However, they paid $80,600 in total federal taxes which, after netting out their average direct benefits, reduced their income by $68,400, or 23 percent. The International Monetary Fund (IMF) says fiscal policy is when governments use spending, interest rates and taxes to influence the economy. Typical goals are to reduce poverty and stimulate strong, sustainable economic growth.

The Risks of Expansionary Monetary Policy

Canada was hit especially hard in the first half of 2016, with almost one-third of its entire economy based in the energy sector. This caused bank profits to decline, making Canadian banks vulnerable to failure. Although fiscal policy gained prominence during world depression of 1930’s, yet its practical application has a number of problems or limitations. The aim of Quantitative easing is to increase the money supply, reduce bond yields and avoid deflationary pressures.

A particular set of fiscal measures may have an excessively harsh impact upon certain sectors, while leaving others almost unaffected. Monetary and fiscal policy are different tools used to influence a nation’s economy. Monetary policy is executed by a country’s central bank through open market operations, changing reserve requirements, and the use of its discount rate.

Local government borrowing

The IMF says to avoid the cons of fiscal policy stimulus spending, governments should follow four principles. The government will change the taxation rates from time to time to mitigate inflation. Businesses thrive more when the taxes have been lowered, and a huge money supply is available. In this situation, taxes have to be raised, and the government has to reduce its spending.

Increasing the fed rate contracts the economy, while decreasing the fed rate increases the economy. In addition, like any government policy, an expansionary policy is potentially disadvantages of fiscal policy vulnerable to information and incentive problems. The distribution of the money injected by expansionary policy into the economy can obviously involve political considerations.

Another factor which will spark a debate over the progressivity of the federal system is the soaring budget deficits generated by the extraordinary relief measures needed to deal with the COVID-19 pandemic. It is uncertain whether additional relief measures will be needed in 2021, but the question of where to find new tax revenues to reduce the mounting national debt will certainly be a backdrop to those discussions. In anti-depression fiscal policy, the expansion of public spending and reduction on taxes are always important elements. The question arises naturally, whether a specific variation in public spending or taxes will bear the desired results or not. In case the injections or withdrawals from the circular flow are more or less than what are required, the system will fail to move in the desired direction. In response to the financial crisis in late 2008 and the subsequent recession, the United States has been running atypically high and persistent budget deficits.

When the central bank purchases debt instruments, it injects capital directly into the economy. Expansionary fiscal policy are policies enacted by a government that often increases or decreases the money supply to make changes to the economy. In other words, governments can directly give money to individuals, businesses, or taxpayers. When central banks lower interest rates by using monetary policy, the cost of borrowing and investment becomes cheaper. However, if the economy is near full capacity, expansionary fiscal policy risks sparking inflation. This inflation eats away at the margins of certain corporations in competitive industries that may not be able to easily pass on costs to customers; it also eats away at the funds of people on a fixed income.

The impact of the monetary policy tools that are used by the central banks of a country have a nationwide impact. Even one choice can be enough to create a ripple effective that can create adverse results just as easily as it can offer benefits. Because it is a macroeconomy decision, there is no way to alter the impact on local segments of the economy which may not need any stimulus. Some regions might even need more help than what is currently offered by the choices made. That means you cannot use monetary policy as a way to solve specific problems or boost industry segments or economic regions. Unlike the expansionary policy, which is set during recessions when the economy is slow and lagging, a contractionary fiscal policy is designated to slow down the economic activity.

The Implications of Fiscal Policy and Monetary Policy to Business

Expansionary policy is also popular—to a dangerous degree, say some economists. Whether it has the desired macroeconomic effects or not, voters like low taxes and public spending. According to Keynesian economists, the private sector components of aggregate demand are too variable and too dependent on psychological and emotional factors to maintain sustained growth in the economy. Fiscal policy is often contrasted with monetary policy, which is enacted by central bankers and not elected government officials. The reality of any financial market is that someone will lose just about every time someone else strikes it big. We are all importers and exporters in some ways, so the only way to guard against the sweeping changes that are made on the macroeconomic level is to switch gears based on what is seen.

To stimulate a faltering economy, the central bank will cut interest rates, making it less expensive to borrow while increasing the money supply. If the economy is growing too rapidly, the central bank can implement a tight monetary policy by raising interest rates and removing money from circulation. To combat these low oil prices, Canada enacted an expansionary monetary policy by reducing interest rates within the country.

Principles of Economics

If a government does not have enough revenue to fund its spending plans, it may borrow from the commercial banks or the public by selling short term securities, called bills, and long term securities, called bonds. Both central and local government may need to borrow heavily from time to time to fund spending commitments. When the economy is overly active and inflation threatens, it may increase taxes or reduce spending. However, neither is palatable to politicians seeking to stay in office.

Bir yanıt yazın

E-posta adresiniz yayınlanmayacak. Gerekli alanlar * ile işaretlenmişlerdir