EFA (29): Fiscal policy, part 2

Last week, we discussed how governments try to use fiscal policy to influence the level of economic activity. Fiscal policy is defined as the decisions that the government takes about the levels of taxation and government spending.

This week, in the 29th item of our Economics for Amateurs (EFA) series, we'll look at the arguments for and against the use of fiscal policy to stabilize the economy.

The argument in favour of fiscal policy is simple. By increasing public spending or reducing taxation, the government can raise the level of demand in the economy.

This then leads to increased output of goods and services and lower unemployment. This was one of the key insights of the British economist John Maynard Keynes in the 1930s.

But there are a number of potential drawbacks to boosting demand through higher government spending or lower taxes.

First, there are time lags between policy decisions and their impact. (For example, between the time decision is taken to build a new hospital and the money being spent or between tax cuts and consumers spending this extra money).

This could mean that the fiscal stimulus comes too late to be effective or takes effect when the economy has already recovered and therefore leads to higher inflation.

Another criticism of higher government spending is that it leads to reduction in (or "crowds out") private-sector spending. One argument  here is that as the government borrows more to finance its spending plans, it pushes up interest rates which makes it less attractive for private-sector firms to borrow for their own investment plans.

A more sophisticated argument is that private individuals and firms will realize that any increase in government borrowing to finance lower taxes now will have to be paid for by higher taxes in the future.

According to this argument, attempts to make people spend more by cutting their taxes will be futile, as intelligent consumers will simply save more to pay their future tax bills.

Many economists believe that fiscal policy can have a short-term impact on output in times of serious recession and high unemployment, but that its long-term impact is less clear. For a detailed discussion of the impact of fiscal policy, see the here.