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US Fiscal Policy - Will It Help Economy


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With concerns over an impending recession, it appears that fiscal policy is becoming more popular amongst politicians and policy makers. For example, in the US, the slowdown in the economy is causing politicians from across the political spectrum to argue for varying degrees of fiscal expansion. As Nixon said in the late 60s, are we all becoming Keynesians again?

How Fiscal Policy Works

Fiscal policy is the governments attempt to influence Aggregate Demand AD, and therefore influence the economic cycle and economic growth. If the government wish to boost domestic demand, they can cut taxes and increase government spending. Lower income tax increases the disposable income of consumers, hopefully causing them to spend more. Therefore, this will cause higher levels of economic growth.

The downside of expansionary fiscal policy is that the government will need to borrow more from the public sector so that they can finance the tax cuts. This increases the national debt and future interest payments, which ultimately the tax payer must pay back.

Why Fiscal Policy May not work

Although in theory the government can influence the level of economic activity. In practice it might be difficult for the government to actually manage demand as much as it likes.

1. Consumer Confidence. If consumer confidence is low, a cut in income tax may not encourage spending. The reason is that they prefer to save the tax cut, rather than spend. Therefore there is no increase in domestic demand. This scenario is particularly likely when taxes are cut for the rich; high income groups have a lower marginal d to consume.

2. Crowding Out. This occurs when higher government spending and borrowing lead to a corresponding decline in private sector investment and spending. The reason is that the government spend more, but borrow from the private sector. If the private sector buy government bonds, it means they have less income to spend and invest. Therefore, the government is merely diverting resources from the private sector to the public sector, and therefore there is no increase in overall Aggregate Demand.

Furthermore, government spending may be more inefficient than the private sector. Also higher levels of borrowing may push up interest rates, further crowding out private sector spending.

However, Keynesians dispute this. They say that in a genuine recession, private sector resources are under-utilised and therefore, the government is merely helping to kick start the economy.

More on fiscal policy and the economic mistakes of politicans

About the Author

Richard Pettinger studied Politics and Economics at Lady Margaret Hall, Oxford University. He now works as an economics teacher in Oxford. He enjoys writing essays on Economic and he edits an Economics Blog focused on UK and US economies:

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Article Published/Sorted/Amended on Scopulus 2008-02-22 11:57:12 in Economic Articles

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