What Is Fiscal Policy
Fiscal policy is the economic term which describes the actions of a government
in setting the level of public expenditure and how that expenditure is funded.
It contrasts with monetary policy, which describes the policies about interest
rates setting and supply of money to the economy.
Method of Raising Funds
Governments spend money on a wide variety of things, from the military and
police to services like education and healthcare, as well as transfer payments
such as welfare benefits.
This expenditure can be funded in a number of different ways:
•
Taxation of the population
•
Seignorage, the benefit from printing money
•
Borrowing money from the population, resulting in a fiscal deficit.
Funding of deficits
A fiscal deficit is often funded by issuing bonds, like Treasury bills or consols.
These pay interest, either for a fixed period or indefinitely. If the interest and
capital repayments are too great, a nation may default on its debts, most usually
to foreign debtors.
Economic effects of fiscal policy
Governments often use their fiscal policy to try to influence the economy towards
economic objectives such as low inflation and unemployment.
According to Keynesian economics, high government spending, funded by a
deficit, can be beneficial to the economy by stimulating aggregate demand and
decreasing unemployment, during a recession.
A corollary of this is that, during a period of inflation, a reduced deficit (or a
budget surplus), can reduce inflation by reducing aggregate demand. This is a
result of the Phillips curve, which describes the link between inflation and
output/unemployment.
The nature of fiscal policy has other economic effects, which are emphasised by
other schools of economic thought. In particular:
•
Government borrowing is held to reduce private-sector borrowing and
investment because of crowding out.
•
The linkage between deficits and inflation via the Phillips curve is
controversial
•
Ricardian equivalence suggests that, since any fiscal deficit must
ultimately be repaid, government borrowing will not affect the economy.
All these factors suggest that the long-run effect of borrowing is much less
beneficial than the short-run effect. To stop governments over-borrowing to meet
short-term objectives, some nations have adopted fiscal policy rules, like the
Golden Rule and the Stability and Growth Pact.
Golden Rule
The Golden Rule is a fiscal rule adopted by Chancellor of the Exchequer, Gordon
Brown for HM Treasury in the UK to provide a guideline for the operation of fiscal
policy. The Golden Rule states that over the economic cycle, the Government will
borrow only to invest and not to fund current spending.
The justification for the Golden Rule derives from macroeconomic theory. Other
things being equal, an increase in government borrowing raises the real interest
rate consequently crowding out (reducing) investment because a higher rate of
return is required for investment to be profitable. Unless the government uses the
borrowed funds to invest in projects with a similar rate of return to private
investment, capital accumulation falls, with negative consequences upon
economic growth.
The Stability and Growth Pact
The Stability and Growth Pact is an agreement by European Union member
states related to their conduct of fiscal policy, to facilitate and maintain Economic
and Monetary Union of the European Union.
It is based on Articles 99 and 104 of the European Community Treaty (with the
amendments adopted in 1993 in Maastricht), and related decisions. It consists of
enforcement policies of mutual surveillance of fiscal positions and of an
excessive deficit procedure defined in the treaty.
The pact was adopted in 1997 so that fiscal discipline would be maintained and
enforced in the EMU. Member states adopting the euro have to meet the strict
Maastricht convergence criteria.
The actual criteria that member states must respect:
 An annual budget deficit no higher than 3% of GDP
 A public debt lower than 60% of GDP or approaching that value
Future negotiations are likely to concentrate on the mechanisms of the Excessive
Deficit Procedure, which is where the broad aspirations of the Treaty text are
realized.
Ricardian equivalence
Ricardian equivalence, or the Barro-Ricardo equivalence proposition, is an
economic theory which suggests that government budget deficits do not affect
the total level of demand in an economy. It was proposed by the 19th century
economist David Ricardo (April 18, 1772 – September 11, 1823).
In simple terms, the theory can be described as follows. Governments may either
finance their spending by taxing current taxpayers, or they may borrow money.
However, they must eventually repay this borrowing by raising taxes above what
they would otherwise have been in future. The choice is therefore between "tax
now" and "tax later".
Suppose that the government finances some extra spending through deficits - i.e.
tax later. Ricardo argued that although taxpayers would have more money now,
they would realize that they would have to pay higher tax in future and therefore
save the extra money in order to pay the future tax. The extra saving by
consumers would exactly offset the extra spending by government, so overall
demand would remain unchanged.
More recently, economists such as Robert Barro have developed more
sophisticated variations on the same idea, particularly using the theory of rational
expectations.
Ricardian Equivalence suggests that government attempts to influence demand
using fiscal policy will prove fruitless. It can be contrasted with alternative
theories in Keynesian economics. In Keynesian models, a multiplier effect means
that fiscal policy, far from being impotent, has a geared effect on demand, with a
one pound increase in deficit spending increasing demand by more than one
pound.
Assumptions of Ricardian Equivalence
Ricardian equivalence states that the level of government deficit does not affect
the level of consumption. This is because people know that their taxes will have
to rise in future to pay off the deficit, and so they save money now to pay off the
future taxes.
To work, this needs several conditions, most commonly:


A perfect capital market where any household can borrow or save as
much as is required.
Intergenerational concern. The tax rise required may not occur for
centuries, and will be paid off by the great-great-grandchildren of the
population around at the time the debt was incurred.
Ricardian equivalence only happens when the current generation has some
concern for all future generations, even if not perfect concern. Barro phrased this
as "any operative intergenerational transfer".
These assumptions are widely challenged. The perfect capital market hypothesis
is often held up for particular criticism because of the existence of liquidity
constraints which invalidate the lifetime income hypothesis which it is based on.
The existence of international capital markets also complicates the picture.
However, the underlying intuition of the Barro-Ricardo model is that individual
action can unravel Government policy, that the economy does not act in a
mechanistic manner, and that policies can have unintended consequences. This
is a key point of modern macroeconomic policy.