State Intervention and Fiscal Policy Explained
State Intervention and Fiscal Policy
Keynesian Economics
Keynesians, followers of J.M. Keynes, reject the assumption of a self-regulating economy reaching full employment. They advocate for monetary and fiscal policies to stabilize economic fluctuations.
Monetarist Economics
Monetarists, influenced by Milton Friedman and the Chicago School, follow classical economic thought. They believe in the free market’s ability to achieve full employment through supply and demand adjustments. For example, decreased consumption leads to lower prices, enabling businesses to sell all production. Unemployed workers accepting lower wages allows companies to hire more, gradually increasing employment and production. Monetarists recommend minimal state intervention, primarily focusing on controlling the money supply.
Fiscal Policy
Fiscal policy encompasses government decisions on public spending and taxes.
Public Expenditure
- Current expenditure: Primarily personnel expenses and purchases of goods and services.
- Capital expenditure: Investments in infrastructure and other long-term assets.
- Current transfers: Payments without receiving goods or services in return, such as social security, unemployment benefits, and family allowances.
Taxes
Taxes are imposed on individuals, households, and businesses by the public sector, based on specific economic events like income or profits. The objectives of taxation include:
- Covering public expenditure
- Reducing the production of certain goods
- Altering income distribution
Fiscal Policy and Economic Activity
Governments use fiscal policy to influence economic activity depending on the economic cycle.
Expansionary Fiscal Policy
During recessions or stagnation, expansionary fiscal policy increases public spending or reduces taxes to stimulate aggregate demand. This can lead to higher production and employment, but also price increases. If wage increases follow price increases, business costs rise, shifting aggregate supply leftward and negating the initial positive effects.
Restrictive Fiscal Policy
During economic expansion, as prices rise, restrictive fiscal policy reduces public spending and increases taxes to curb inflation. This shifts aggregate demand leftward, reducing production and prices.
The Public Sector Budget
The public sector budget outlines planned spending and revenue for a given period. Government revenue funds public sector objectives and covers expenses. Public spending represents payment obligations incurred by the public sector. A public deficit occurs when expenses exceed revenues, while a surplus occurs when revenues exceed expenses. The budget is a crucial policy tool for influencing economic activity.
Budget Documents
Budget documents typically include:
- General economic objectives
- Detailed expenditure and income
- Macroeconomic policy instruments
Managing Public Deficits
Two ways to address a budget deficit include:
- Increasing taxes (often unpopular)
- Issuing public debt (selling bonds to citizens with a promise of repayment with interest)
Public debt increases during deficits and decreases during surpluses. Higher public debt also increases government spending due to interest payments.