EFA (28): Fiscal policy, part 1

The recent recession has again highlighted the question of what governments can do to influence the level of economic activity.

One policy that has been used is monetary policy. This is the manipulation of the level of interest rates or of the supply of money. We have seen central banks around the world reducing interest rates aggressively to encourage consumers and companies to borrow and spend more.

The other key weapon in a government's arsenal is fiscal policy. This is the subject of the 28th item in our Economics for Amateurs (EFA) series, which you can find here every Monday.

But what exactly is fiscal policy? Put simply, it is the decisions that the government takes about the levels of taxation and government spending.

Each time the government spends money — for example, on a contract to build a new motorway — it is increasing the level of demand for goods and services in the economy. And each time the government raises taxes, it is taking money away from consumers and firms and in this way potentially reducing their levels of spending.

If the government spends more than it raises in taxes it has a budget deficit and is, on balance, pumping money into the economy. If it raises more in taxes than it spends, it has a budget surplus and is, on balance, withdrawing demand from the economy.

One of the key insights of John Maynard Keynes in the 1930s was that, at times of high unemployment, governments should increase their spending programmes to stabilize the economy.

Economists typically distinguish between two types of fiscal policy: automatic stabilizers and active (or discretionary) policy.

Automatic stabilizers are taxes or forms of government expenditure that change automatically in response to changes in output. For example, when output falls, income tax receipts are reduced without any change in the tax rates. And government spending on unemployment benefits increases. These effects help to stabilize the level of demand.

Active or discretionary fiscal policy, on the other hand, is when the government takes deliberate decisions to change its spending — for example, the "cash for clunkers" programmes or new infrastructure investment — or to change the rates of taxation.

Sounds simple, doesn't it? So why don't governments simply fine-tune their fiscal policy to keep the economy at full employment all the time? There are many reasons why fiscal policy may not work in this textbook way. We will look at those next week.