What is fiscal policy?

What is fiscal policy refers to?

It is common knowledge that a nation regulates its economic growth through the implementation of monetary policy and fiscal policy.

Fiscal policy refers to the government’s use of taxation and public spending to influence the overall economy.

There are two main components of fiscal policy:

Government spending:

This refers to the money that the government allocates to finance public goods and services. Public goods include areas such as infrastructure development (roads, bridges, public transportation), education, healthcare, defense, social welfare programs, and more. By increasing government spending, the government can directly inject money into the economy, which can create jobs, boost demand for goods and services, and stimulate economic activity.

Taxation:

Taxes are levied by the government on individuals, businesses, and other entities, and they provide the government with revenue to fund its spending. Taxation affects disposable income, consumption patterns, and investment decisions. By adjusting tax rates or structures, the government can influence the amount of money available for private consumption and investment. Lowering taxes can increase disposable income, leading to increased consumer spending and business investments, while raising taxes can have the opposite effect.

Example:

When the government opts to raise taxes, it reduces the flow of money, leading to a slowdown in the economy. Conversely, if the government chooses to lower taxes, it increases the amount of money circulating, resulting in an improved economic performance.

What becomes evident is that there exists a reverse correlation between taxes and economic performance. Thus, reducing taxes results in an improved economy, while increasing taxes leads to a decline in economic conditions.

It’s not as straightforward, as taxes are typically utilized for government spending. When the government raises taxes, it is often to fund various public goods and services, including infrastructure development, education, healthcare, defense, social welfare programs, and more. However, governments may also resort to borrowing funds to cover their expenditures, leading to increasing levels of debt.

The process of raising taxes and spending more than the revenue generated occurs when the government sells government bonds to borrow money. By doing so, they can finance additional spending beyond what they collected through taxes. This can result in a positive impact on the economy since the increased spending stimulates economic activity.

On the other hand, if the government lowers taxes but reduces spending on vital stimulatory elements such as infrastructure projects things that simulate economy, it may negatively impact the economy. Moreover, if the money saved from tax cuts is used to repay existing debts rather than being reinvested into the economy, it can further hinder economic growth. considering both aspects is essential.

However, the favorable aspect is that the US government often spends more than it earns in taxes, leading to a continuous accumulation of debt. As a result, there is a situation where significant spending already stimulates the economy. When taxes are lowered in such circumstances, it can be expected to further invigorate the economy. Thus, reducing taxes becomes a potent way to stimulate economic activity.

Techniques used in fiscal policy

Expansionary fiscal policy:

This approach involves increasing government spending and/or reducing taxes to stimulate economic growth during times of economic downturn or recession. By injecting more money into the economy, the government aims to boost aggregate demand, create jobs, and encourage businesses to invest and grow.

Contractionary fiscal policy:

This strategy is implemented during times of economic expansion when there is a risk of high inflation or an overheated economy. The government may decrease spending and/or increase taxes to reduce aggregate demand and cool down economic activity, thereby controlling inflation.

Automatic stabilizers:

These are mechanisms built into the tax and welfare systems that automatically adjust government revenues and expenditures in response to changes in economic conditions. For example, during an economic downturn, tax revenues tend to decrease while spending on unemployment benefits increases, helping to stabilize the economy.

Conclusion

Fiscal policy can have both short-term and long-term impacts on the economy. Its effectiveness depends on various factors, such as the size of the fiscal stimulus, the responsiveness of consumers and businesses, the timing of policy implementation, the level of public debt, and the overall economic conditions.

As short-term traders, fiscal policy is not our primary focus for investing. Nevertheless, we are keen to understand how any changes in fiscal policy can impact the broader market.