Fiscal Policy: How It Works?

Fiscal Policy

Fiscal policy is the use of government spending and taxes to influence the economy. Long-term fiscal stabilization is achieved by well-planned regulation of taxation rates and government spending. Stable taxation and spending aimed at potential funding commitments decrease tax costs on residents and lower interest rates. Taxation and government budgets are cited as key contributors to inflation. Inflation harms the economy by increasing the value of goods and services, as well as the pace of interest rates. As a result, a sustainable monetary policy means that inflation is kept under check, thus leading to long-run economic development. If the government debt is kept at reasonable levels, the cost of borrowing reduces lowering the level of interest rates. Thus a sustainable fiscal policy ensures that inflation rate is controlled and consequently contributing to long-run economic growth. If the government debt is kept at reasonable levels, the cost of borrowing reduces lowering the level of interest rates. In other words, if the government budget decrease, it will require fewer funds to finance its obligations. It will therefore reduce borrowing from the market hence decreasing the demand for the debt facilities. Lenders will be forced to reduce the cost of lending making more investors borrow funds, invest and as a consequence economic growth is realized.

Sustainability of Fiscal Program

Sustainability of the fiscal program helps in eliminating the unexpected adjustments and sudden risks arising from volatility in rates of taxation and government expenditures. Therefore, certainty in the economy is created which increases the level of private investment, translating into macroeconomic stability and long-run growth objectives of the government. Any volatility in the fiscal policy components leads to an increase in exchange rates, interest rates, and cash flow rigidities. Thus, long-term fiscal sustainability stabilizes, exchange rates, interest rates, and level of cash flow promoting growth. Besides, levels of inflation and interest rates increase foreign direct investment adding to GDP and consequently promoting growth. The stability in the taxation rates minimizes the costs of raising taxation revenues and thus improving the taxation welfare and taxation smoothing which becomes an automatic stabilizer of macroeconomic growth.

Government Budget and Long Run Investment

The figure below depicts the market for loanable funds with demand curve, supply curve, and equilibrium interest rates. The demand curve is downward sloping owing to the fact that at low levels of interest rates, individuals and firms borrow more money for investment. At low-interest rates, low costs borrowing encourages higher quantities of loans borrowed for investment. On the other hand, the supply of loanable funds increases with an increase in interest rates because the lenders are able to make more revenue from the money borrowed by individuals and firms.

Q2 Q0 Q1

SL

DL

r1

r0

r2

Interest rate

Loanable funds

The level of investment depends on the rates of interest in an economy. It affects the investor’s desire to borrow loans influencing the investment made by the private business. A failure to present a credible balance plan of the government budget in the long run affects the private business investment. This is because an increase in the government budget increases the level of taxation in the economy. Due to this, the level of inflation coupled with interest rates in the economy increases in order to balance the increased level of taxes. Using the loanable funds model, the economy is at equilibrium at ro and Qo. However, an increase in government budget causes an increase in interest rates to a new level r1. The increased interest rates make the cost of borrowing loanable funds to be high and thus the level of investor borrowing reduces to quantity Q1. At this point, there is considerably reduced borrowing level which makes the level of investment in the economy decrease. If the government does not address the problem related to the level of the budget, the level of interest rates will remain at r1 and that of loanable funds demanded by business individuals at Q1, thus affecting the long-run level of investment in the economy.

Conclusion

McKinsey Global Institute was right to conclude that long-term fiscal sustainability is significant for economic growth. This is because it creates stability in interest rates, which increases the level of investment in the economy. The level of taxation is also maintained at healthy economic levels, while at the same time, the government spending is controlled for the purpose of economic growth. Economic efficiency is achieved, and the budget level of the government is managed for the growth of an economy. If the level of investment increases, the level of GDP also increases, and more employment opportunities are created. Long-term fiscal sustainability is significant for economic growth as it ensures that taxation and spending are fairly distributed across generations.