Countercyclical Fiscal Policies
Countercyclical fiscal policies are measures and tools used by the monetary authority of the government to address the business cycle. The main fiscal tools employed by the government are taxes and public spending (Akitoby, et al 2019). When the economy is in a slump the government will use the expansionary fiscal policies, which involve reducing taxes and increasing its spending thus encouraging investment and employment opportunities that generate growth in the economy. On the hand when the economy is in a boom the government institutes the contractionary fiscal policies which entail reducing public spending and increasing taxes to restore economic equilibrium. Therefore, the rationale for government intervention stems from the need to prevent sudden economic flights.
Another plausible need for government intervention is a market inefficiency that arises from the market-based economy. A market-based economy cannot be sustained unless there are sound economic policies to manage and control the self-seeking motives of individuals. A market-based economy is characterized by failures such as externalities, imperfect information and inadequate provision of public goods. Externalities are common in the marked-based economy and they can either be positive or negative. Positive externality benefits a section of the economy without the producer gaining from such benefits. On the other hand, negative externalities occur when a section of the economy is affected while the producer of those effects loses nothing. Therefore, from time to time the government will intervene to ensure that social marginal benefits supersede the social marginal cost and the economy is stable.
The countercyclical fiscal policies generate a plethora of impacts on various economic agents. Reducing taxes leads to an increase in consumer disposable income thus leading to an increase in the aggregate demand. Increased demand stimulates more production resulting in an increase in the overall output. Additionally, increased government spending contributes directly to the overall economic growth through increased employment. On the other hand, fiscal policies can result in damaging effects for instance, if the government borrows to finance budget deficits through the issuance of Federal bonds. Guerguil, et al (2017) noted that borrowing domestically leads to an increase in the interest rates thus the private sector is crowded out and private investment shrinks. Similarly, when the government borrows to finance its increased spending to boost the economy the long-run effect is a strained economy. The maturity of the government debt instrument like a Federal bond requires that government pay the principal amount plus the interest this reduces the amount that the government can spend on the development activities. Contextually, in the open market economy the expansionary fiscal policies result in exchange rate appreciation making imported goods less expensive and the US exports more expensive in the global market. The unattractiveness of the US exports generates the balance of payment deficit which negatively impacts the GDP.
The countercyclical fiscal policies may be a cost to the government and they may not bring the immediate intended impacts on the economy. One such rationale for this argument is the lag effect. This effect postulates that there is a lag between the time when the government takes the corrective measures and the time the economic swing happened. For instance, when the government decides to reduce taxes to boost the economy a certain section of the economy would have already suffered. Notably, the countercyclical fiscal policies can also result in a cost to the government. For instance, in an open market economy, the expansionary policy could result in the foreign exchange appreciation and the government will be forced to intervene to protect the value of the dollar thus leading to the cost on the government.
The countercyclical fiscal policies have dominated the economic discourse for ages. The proponents of these policies led by famous economist John Keynes postulated that fiscal policies are a panacea to economic swings. According to, Eichengreen (2020), Keynesian economists argued that when the government increases public spending and reduces taxes it improves aggregate demand thus economic growth. Keynes further advocated for government borrowing to fill the budget deficit as one way of encouraging growth and the creation of employment. On the other hand, the classical economists led by Milton Friedman refuted the economic policy espoused by Keynes and argued that the fiscal policy intervention was ineffective. He advocated for market deregulation as a way of economic restoration and negated the Keynes view on deficit spending. Milton posited that the deficit spending was unsustainable in the long run and the government should return to a market-based economy and application of monetary policies as a way of managing the economy.
Government intervention through the fiscal policies effects will continue to be used by many governments in the foreseeable future. As outlined in the discussion, a market cannot sufficiently sustain itself without an adequate regulatory framework. For instance, during the 2007 global economic swings, the US mortgage industry was adversely affected and the government was forced to intervene (Olbrys, 2021). The government responded through two channels, fiscal stimulus and economic stabilizers and the overall effect was economic stability. However, the continued application of fiscal policies should be limited in the short run since an extended fiscal policy could damage the economy since the government intervention through increased spending could result in a debt trap. Additionally, the governments should modify the fiscal policies by allowing some degree of deregulation and only tighten the net when it perceives an impending economic swing.
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References
Akitoby, M. B., Honda, M. J., & Miyamoto, H. (2019). Countercyclical Fiscal Policy and Gender Employment: Evidence from the G-7 Countries. International Monetary Fund.
Eichengreen, B. (2020). Keynesian economics: can it return if it never died?. Review of Keynesian Economics, 8(1), 23-35.
Guerguil, M., Mandon, P., & Tapsoba, R. (2017). Flexible fiscal rules and countercyclical fiscal policy. Journal of Macroeconomics, 52, 189-220.
Olbrys, J. (2021). The Global Financial Crisis 2007-2009: A Survey. Available at SSRN 3872477.