The fiscal and monetary policies are two major tools used by the government by control their country’s economies. The fiscal policy has two major parts under it namely government spending and tax rates (Theodore 2009, p 121). An expansionary fiscal policy is one where the government seeks to increase a country’s growth by tax cuts (leaving people with more disposable income to spend on goods and services) and a growing number of government projects (which creates employment and job opportunities for the citizens). The US government also seems to be following such a policy.
An expansionary fiscal is only expected to work under two basic assumptions: 1. that initial government spending does not depress private spending or expenditure 2. that the expansionary policy affects only the demand (and not supply side) of the economy Also such a policy may only work if the political climate is suitable (Mahendra 2008, p 301). That means that it has often been seen that as elections get nearer, governments start opting for an expansionary fiscal policy regardless of whether it is suited to the times.
Some economists also state that with an expansionary fiscal policy, the financing climate should be such that some of the effects are not dissipated in the form of inflation. 2. under what conditions the policy would fail, An expansionary fiscal policy would fail as discussed above if: 1. initial government spending depresses private spending or expenditure (a phenomenon known as crowding out) 2. If the policy affects also the supply side of the economy To further elaborate the first point, the government can depress private spending by competing for funds with private investors in its bid to increase its spending.
Interest rates may be driven up with this competition and this may discourage private spending. This phenomenon is called crowding out because as the government tries to encourage an increase in the real GDP through increased spending, the private sector will be decreasing this spending which may be less, equal or more than the government increase. If the decrease is more or equal, the government will not be able to have the desired effect it had hoped through its fiscal policy. The second point illustrates that if the government does not follow a permanent tax rate cut, the supply side of the economy may be affected.
Investors may be discouraged by the higher taxes and may consequently move by decreasing supply thus shifting the AS curve inwards. This would not have the required effect the government hoped to achieve through an expansionary fiscal policy and will only create an inflationary gap in society with no change in the level of GDP but a higher price level for all the available goods and services. Also there is the Lammer Curve effect which shows that tax rates and tax revenues are only directly related up to a certain level.
As soon as tax rates surpass a specific rate, revenues and rates start sharing a negative relationship. 3. State your opinion as to whether or not the US policy will work I believe the US government policy may or may not work for a variety of reasons. The policy may work towards stimulating growth in our country’s economy because that is what most economists in theory suggest. If government cuts down on taxes, people will have more disposable income to spend money on (Todd 2004, p 111). This will mean an upwards shift in the AD curve that will increase the GDP.
Similarly, an increase in government spending will create more jobs and income for people who will in turn spend more on themselves. This will also mean an upwards shift in the AD curve which in turn will increase GDP. In theory, it may seem so far so good. But it may not work because the government aims to increase its spending and according to economists, increased spending should be financed by higher taxes so that people can know the cost to the government of such spending. But the government wants to increase spending through borrowing.
It is proposing tax cuts along with this increased borrowing and such a high level of borrowing may bring along inflationary pressures with it. Similarly, taxes should actually be more drastically increased for the upper class of the American society (such as the bankers, industrialists and financiers) who the average American citizen is blaming for the current financial crunch. In short, the income form the increased taxes should be used to partly fund government spending to reduce pressure on the dollar from a huge borrowing bill.
Furthermore, if the above mentioned crowding out effect occurs, the US policy may also not work then. Then there are the usual problems associated with the implementation of any policy such as the time lags, recognition lag, administrative and operational lag. Bibliography Theodore, E. B. 2009, FINANCIAL CRISES, CreateSpace. Mahendra, S. , 2008-09 World & Financial Prophecies, Self Publisher. Todd, A. K. 2004, Recessions and Depressions, Praeger Publishers.