Thursday, 16 August 2012

Your Humble Guide to Public Finance II. – Fiscal policy

In the second post of our series on public finance, we will now cover fiscal policy, which – as briefly mentioned in the first post – controls government spending and revenues with the aim of maintaining macroeconomical stability. Read more about aggregate demand, fiscal stimulus and the like, below.

What is it for?

Fiscal policy aims to control the aggregate demand(AD) of a country's economy by government spending – the total demand for final goods in the economy. That sounds nice – but what makes up aggregate demand? As simple as it may sound, only four factors – and one of them is directly government spending. Beware, a mathematical formula is coming up. To make things easier, let's use the example of your imaginary family farm and your local city council.

AD = C + I + G + NX

or in other words:

Aggregate Demand = Consumption + Investment + Government spending + Net exports

Consumption: the demand by unattached individuals and households. (Imagine yourself going down to the shop to buy a candy.)

Investment: the total spending of the private sector, aimed at producing something consumable in the future (Your dad, a farmer, buys a bull besides the family cow, in order to sell the calf's meat later.) 
Government spending: the combined amount of government investment and consumption (The city council hires an economic adviser (consumption), who in turn recommends the council to buy your family a bull (investment – in this case, a.k.a. government stimulus) to increase your farm's productivity.)

Net exports: the sum of total imports and exports of an economy. (Your dad buys the bull from China. However, he exports the cow's milk to Canada. If the sold milk costs more than the bought bull, that makes the family a net exporter.)

How is it done?

There are two ways of influencing aggregate demand by the government – taxation, and expenditure. Taxation (you giving milk to the city council) – besides giving money to the government to spend, see above – decreases aggregate demand (less money, less consumption and investment). Expenditure, on the other hand, increases aggregate demand by increasing government spending (buying more bulls), which in turn leads to increased private spendings (Don't forget that your state-bought bull's offspring will produce milk as well).

Types of fiscal policy

There are three main types of fiscal policy, neutral, expansionary, and contractionary. Neutral fiscal policy means that government spending is completely funded by taxes (you get back the exact cost of the given milk in say, bulls). Expansionary fiscal policy means that the government spends more than it earns, increasing it's debts, which is usually done in a recession (Your family cow died. You can't produce goods, so the council has to bail you out by buying a cow as well, meaning they'll have uncovered spending, given that you can't pay them back with milk). Contractionary fiscal policy means that the government earns more than it spends. (The city council has debts, so when you ask them to buy a second cow for you, they turn you down.)

Alternative government funding

Finally, as it was mentioned above, tax revenues do not always cover the government's costs. What can be done then in order to avoid government bankruptcy? The main methods are borrowing, consumption of reserves, sale of fixed assets and government enterprises.

Borrowing: the government sells bonds at a fixed price, promising to pay back the loan gained by purchasing the bond in installments, with an additional interest rate. (You buy a Ten-Year Cow Bond with an interest rate of 10% from your government at the price of 100$, with the hope of receiving 11$ each year for 10 years.)

Consumption of reserves: consumption of the government's own financial and other reserves to pay back debts. (The city council starts to drink the 'tax-milk' instead of selling it.)

Sale of fixed assets: The selling of government property to fund debts. (The city council sells a pitch of land to you, where you can grow forage for your cows.)

Government enterprises: Using the profits of government companies to fund other governmental expenses, instead of re-investing the money in the companies. (The government creates it's own cow farm, and they give the milk to their creditors.)


The goal of fiscal policy is to influence aggregate demand, and setting it to an acceptable level. The government can to this by taxation (decreasing), or spending (increasing). The government may also choose to spend more than it earns (producing a net increase in aggregate demand, but also an increase of debts), but then it has to pay back it's debts by additional borrowing, consumption of reserves, sale of assets (a.k.a. privatisation) or using the income of government enterprises.

Our next post will cover the role of monetary policy regarding macroeconomical stabilisation, concluding our series. Follow us on RSS to find out about the concluding piece.

1 comment:

  1. Very nice post. Gives out exactly what you need to know about Fiscal Policy without going into much unnecessary detail. Your first part of the series was great in introducing the concepts you will deal with later on as well. Looking forward for the rest.