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Understanding Fiscal Policy and Budgets

Fiscal policy involves government budget management to influence aggregate demand and GDP through components like consumption, investment, and government expenditure. It can be expansionary, increasing demand and stimulating the economy, or contractionary, reducing demand to control inflation. Budgets can be balanced, deficit, or surplus, each affecting economic activity differently, while government revenue sources include tax revenue, non-tax revenue, and grants.

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26 views2 pages

Understanding Fiscal Policy and Budgets

Fiscal policy involves government budget management to influence aggregate demand and GDP through components like consumption, investment, and government expenditure. It can be expansionary, increasing demand and stimulating the economy, or contractionary, reducing demand to control inflation. Budgets can be balanced, deficit, or surplus, each affecting economic activity differently, while government revenue sources include tax revenue, non-tax revenue, and grants.

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Sub Topic: Fiscal Policy 07/06/22

Fiscal Policy
- It is the use of the government’s budget to influence the total demand for goods and
services or aggregate demand.
- The components of aggregate demand are:
Aggregate Demand (C + I + G + X – M)
 Consumption Expenditure
 Investment Expenditure
 Government Expenditure and
 Net Exports

These are components of GDP, therefore, fiscal policy influences the level of GDP and it is often
referred to as Budgetary Policy, because it concentrates on Government Expenditure, Taxes, and
Public Debt.

When the government increases its expenditure, that means more money is in the hands of the
people. The government increases expenditure by increasing public servants’ salaries, undertaking
more development projects, expending public service, granting cash subsidies to producers, school
fees subsidies, scholarships and unemployment allowances to needy people, expenditure on
government health and education services and etc.

When people receive more money, they demand more goods and services, this stimulates economic
activities and producers will produce more goods and services if economic resources are not fully
employed. However, if economic resources are fully employed. This contributes to inflation as
people compete with each other for limited stock of goods and services in the economy.

Conversely, a decrease in government expenditure results in less money flow to the people. Fiscal
policy reduces the economic activities and finally may lead to deflation, which is reduction in prices.

A change in the tax rates also has an impact on the real income of the people. If tax rate is increased,
income available for spending (disposable income) will also be reduced. This means aggregate
demand can be reduced by increasing taxes. On the other hand, if tax rate is reduced, income
available for spending will increase. This may result in increased demand for goods and services.

The above explanation clearly shows that by manipulating the amount of money in the hands of
individuals and businesses, the government is able to increase or decrease the level of total
output of the economy which is the GDP.

Two main Fiscal Policies


1. Expansionary Fiscal Policy – the government spending more than the revenue to increase
the demand for goods and services.

Under this policy the budget is in deficit. Expansionary budgets stimulate economic activities. The
degree to which higher demand increases aggregate output and inflation depends on the state of
the economy. If the economy is in recession, it has unused productive capacity and unemployed
workers. In such situation, output can be increased without affecting inflation, if the economy is at
its full employment, this policy will have more impact on inflation and less impact on the total
output because there is an excess demand. During a recession, expansionary fiscal policy will help
to bring the output to the normal level and increase employment.

2. Contractionary Policy (deflationary) Policies – this policy involves less of government


spending than the government revenue, the budget is in surplus.
It slows down economic activities because less income flows in to the hands of people and
businesses. During a boom period contractionary policy is useful to slow down the economic
activities and in turn control inflation. This may cause unemployment. In such situation preference
is given to address inflation rather than unemployment.

Budget
A budget is a statement of estimated government expenditure and revenue for the forthcoming
fiscal year. The fiscal or financial year varies from country to country. The budget clearly shows the
amounts and sources of government or itemized lists of revenue and expenditure for various
government activities, listed under different departments, ministries and other agencies.

The department of finance and treasury is responsible for preparing the annual budget. The minister
for finance and treasury presents the budget to the parliament for debating and passing. Once it is
passed, it becomes a law, only then the department of finance and treasury will have authority to
collect revenue and incur expenditure to government departments, ministries and agencies.

Types of budgets
1. Balanced Budget– where estimated expenditure equals revenue.
‘Live within means’ spend how much you earned. (Expenditure = Revenue)
2. Deficit Budget – a budget that estimates excess of spending over revenue. (Expenditure >
Revenue) When the government assumes huge responsibility to achieve economic growth it
has to spend more than the revenue and cannot ‘live within means.’ The deficit is financed
by borrowing. Most developing use deficit budgets to finance development projects.
3. Surplus Budget – A budget that estimates less spending compared to revenue. (Revenue >
Expenditure). Surplus budget is possible when there is a boom in the economy where
individuals and businesses are receiving huge incomes. To prevent inflationary effects, the
government may increase tax rates, this decreases spending (Less money in the public). The
higher tax revenue leads to a surplus in the budget.

Qs: What the effects of these three types of budgets in the economy?

1. Surplus Budget
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2. Deficit Budget
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3. Balanced Budget
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Three main sources of government revenue:

A. Tax revenue – Taxes imposed on income and profit, goods and services.
B. Non-tax revenue – Includes property income, interests and fees.
C. Grants – Grants or donations from foreign multilateral institutions to a country.

Common questions

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A government can address inflation with contractionary policy by reducing spending, which curtails demand-driven price increases but can increase unemployment by slowing economic activity. Conversely, addressing unemployment through expansionary policies stimulates the economy, potentially increasing inflation if demand outstrips supply. The trade-off involves balancing inflation control with employment levels .

The government uses its budget through fiscal policy tools like adjusting spending and taxes. During recessions, it may increase spending or cut taxes to inject money into the economy, stimulating growth and employment. Conversely, during inflationary periods, it may reduce spending or increase taxes to control demand, stabilizing economic growth .

During a recession, an expansionary fiscal policy can increase output and employment without significant inflation, as there is unused productive capacity and unemployed workers . In contrast, when the economy is at full employment, the same policy has a higher impact on inflation and less effect on output, due to excess demand .

Implementing a contractionary fiscal policy during a recession could further reduce economic activity by decreasing government spending, which reduces money flow to the public and businesses, potentially exacerbating unemployment and slowing economic recovery, as it aims to curtail inflation rather than stimulate growth .

Tax revenue provides a stable basis for government budgets, affecting fiscal policy through rates impacting disposable income and demand. Non-tax revenue can supplement taxes, reducing reliance and maintaining fiscal balance. Grants offer external resources, influencing investment in development without immediate tax increases, impacting how aggressive fiscal policies can be .

Fiscal policy adjusts GDP by influencing aggregate demand through government spending and taxation. During low economic activity or recession, expansionary policy with increased spending stimulates demand and GDP growth. In high-inflation or full employment, contractionary policy reduces spending, moderating GDP growth to stabilize inflation .

Government spending injects money into the economy, influencing aggregate demand and GDP. During expansionary policy, it can boost economic activity and employment, especially in a recession. Public debt finances budget deficits, enabling sustained spending beyond revenue but may lead to inflation if resources are fully utilized .

Increased taxation reduces disposable income, thereby decreasing aggregate demand and potentially slowing economic activity. Conversely, lowering taxes increases disposable income, raising aggregate demand and stimulating economic activity by providing consumers more money to spend on goods and services .

A surplus budget during an economic boom could help control inflation by reducing money in the economy through higher taxes, leading to decreased spending. This, in turn, reduces disposable income, which can counteract inflationary pressures that arise in a booming economy .

A balanced budget maintains equilibrium between revenue and expenditure, stabilizing the economy without stimulating or contracting it. A deficit budget, however, implies higher spending than revenue received, stimulating economic growth through increased government spending, often financed by borrowing, but potentially leading to higher debt and inflation .

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