Fiscal Policy

1 Fiscal Policy Fiscal policy is the process through which the government allocates the revenues it collects to various uses, and adjusts its tax rates and spending to facilitate the growth of the country’s economy. The use of government revenues and expenditure to influence the performance of the economy began after the Great Depression when the United States government realized that it had to intervene in order to resuscitate the economy. A fiscal policy, when well executed, leads to reduced inflation and higher levels of employment.

To yield the best results, fiscal policy is usually combined with monetary policy. The aim of a fiscal policy is to increase the rate of economic growth and ensure that the prices of commodities are stable. Fiscal policy is founded on the principles of Keynesian economics which affirms that governments have a significant role to play in creating a stable economic environment. Failure to implement an effective fiscal policy may affect the economy adversely, and even lead to recession.

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Interaction of Fiscal Policy with other Policies Fiscal policy when used together with monetary policy work together to create a stable macroeconomic environment due to the complementary roles they play. The fiscal policy is used to increase productivity, therefore influencing the goods market; while the monetary policy is used to stabilize the interest and inflation rates, thus influencing the asset market (Cox, & Tanous 11) Although the fiscal and monetary policies are designed by different bodies, they are highly interdependent. A change in one will inevitably have an influence in the other. To maintain economic stability it is crucial to maintain a consistent mix of monetary and fiscal policy.

How does fiscal policy interact with other policies, such as a tax policy or regulatory policy?

Fiscal policy is used together with various other policies to create a stable economic environment. Fiscal policy interacts with tax policy by taxing the populace in order to earn revenue. Monetary policy refers to the activities that the central bank undertakes tp ensure that the country’s economic objectives are achieved. These involves controlling the amount of money circulating in the economy such that it is neither too much nor too little, controlling interest rates, and ensuring the stability of prices (Newman 22). The overall goal of the policy is to promote the stability of the economy in order to facilitate its growth and development.

Taxes are a significant tool in the design and implementation of a fiscal policy. The government earns the revenue that it uses to grow the economy from taxing its citizens. In addition to the tax, fiscal and monetary policies, the government also controls the economy through regulatory policy. The aim of this policy is to protect the rights of consumers and producers, and to allow them to interact freely in the market (Krugman 83). Fiscal policy

3 interacts with regulatory policy to ensure that the government intervenes when necessary to ensure that producers do not take advantage of consumers through overpricing goods and services. This helps to control the economy’s level of inflation.

How can fiscal policy help smooth the business cycle through “expansionary” and “contractionary” stances?

Economic recession affects the economy adversely since it reduces the rate of unemployment and causes a low level of money circulation in the economy. The populace suffers since it has less spending power, and a lower rate of savings. An expansionary fiscal policy is used as an instrument to end recession and restore the economy back to normalcy. It involved increasing money circulation by raising the aggregate demand. The government expands the economy during periods of economic downturn by increasing its spending in order to pump money into the economy, lowering the tax rate to increase people’s disposable income, and increasing the level of government transfers. Expansionary fiscal policy demonstrates that one of the most effective solutions to a recession is to increase the government’s and the populace’s consumption. This is achieved through cutting the tax rates, encouraging businesses to produce more, and increasing the government’s expenditure on the goods and services produced by these businesses. The objective of these strategies is to raise the level of aggregate demand (Newman 56).

During periods of economic inflation, there is an overproduction of goods and services, and as a result, the level of supply exceeds the level of demand. A contractionary fiscal policy reduces output in order to restore the economy back to normal. This is achieved through increasing the tax rate and reducing government spending.

Multiplier Effect of Government Spending

4 Whenever the government increases its rate of investment, such as through the construction of transport infrastructure, it results in a significant increase in national income.

For instance, if the government spends $1 billion in constructing a major highway, and this causes the GDP to increase by $2 billion, this would be termed as a multiplier of 2.0. The value of the multiplier, therefore, is derived by dividing the change in GDP by the change in the government’s capital injection.

The multiplier effect is determined by consumer’s ability to spend and to save; these are known as the marginal propensity to consume and the marginal propensity to save.

Spending is important to the growth of the economy because when an individual spends, it becomes the income of another individual. When there is more spending, there is extra income, allowing people to accumulate wealth through investments and savings. The multiplier effect is particularly effective in fostering the growth of the economies of developing countries; if consistently and effectively implemented, may lead to a period of economic boom.

Evolution of Fiscal Policy Until the Great Depression that occurred in the 1930s, the government had a laissezfaire approach to managing the economy. The Great Depression had a severe adverse impact on the economy of not only the United States, but several countries around the world, leading to the government’s intervention. In the course of the century, fiscal policy has been refined such that it not only addresses issues of economic recession, but is also used to address more complex issues such as government debt management, economic inequality, and climate change.

2. MONETARY INTEGRATION AND FINANCIALIZATION

5 In the past century, the rate of globalization has increased significantly, and with it, an increase in the integration of economies and financial systems around the world. One of the main ways through which this has been achieved is the expansion of banking institutions across borders, thus facilitating the exchange of funds between states (Newman 71).

Securities markets have also expanded their operations internationally, making it possible for people and institutions across the world to trade in other countries’ securities. Globalization has increased the level of foreign direct investment, giving rise to a high number of multinational corporations.

In the last century, economic globalization has been driven by three main factors.

Firstly, improvements in transportation and communication infrastructure have allowed a greater level of economic integration among states. Secondly, in the course of the century, individuals, businesses and countries have learned that they can gain from taking advantage of the economic integration, and thus have participated in it more actively. Thirdly, countries are increasingly shaping their trade and public policies to fit into a more globalized world, hence accelerating the pace of economic integration. All these developments have contributed to financial globalization.

Financial globalization can be defined as the financial integration between states that occurs as a result of linkages through trade. The late 20th century has been characterized by a higher rate of economic integration and financial globalization. These developments were driven by an increase in international lending by multinational banks, and an increased level of global lending by governments, particularly of industrialized countries.

In the last century, the volume of cross-border trade has risen substantially. Whereas a century ago, developed countries traded amongst each other, over the years there has been a

6 surge of trade between industrialized counties and developing countries. The higher level of international trade has opened up countries to capital inflows and outflows, and also increased the vulnerability of countries to financial crises. Financial globalization is crucial because it helps countries to stabilize their aggregate output and consumption. A country is able to transfer some of its income risks to outher countries. For instance, if a country produces excess quantities of a product, instead of incurring a loss, it can sell off the surplus goods to a state that needs them. At a high level of financial integration, countries achieve a higher level of development than where there is a low level of financial integration.

Financial Arrangements under ‘Embedded Liberalism’ The economic recession of 2007 began in the United States and gradually spread to several countries across the world. It revealed that while globalization had several merits, its main demerit was that it could quickly lead to the collapse of the global economy. Strong economies such as the United States have the potential to affect the world economy because over 80% of transactions across the world use the US dollar (Wolfson, & Epstein 32). This high rate of foreign exchange transactions benefit the US economy because it prevents it from collapse, but in case of a down turn in the US economy causes the global economy to quickly become affected.

In international trade, embedded imperialism refers to the dependency of smaller less developed economies on larger industrialized economies. Smaller economies essentially work towards enriching larger economies and their elites. The industrialized economies create the dependency through exploitative terms of trade such as paying low wages and obtaining goods at lower than market price and selling at a high price. It also involves the exploitation

7 of natural resources, and imposing trade restrictions that ensure that developing countries are not able to engage in significant trade with the country.

The United States dollar was established as the global trading currency through the Bretton Woods system of 1944. The system was created by the World Bank and IMF, and involved all the countries that were involved in World War II (Salsman 68). Members of this system agreed that they would use the dollar as their standard currency and would avoid trade wars among each other. The Bretton Woods system gave member countries a tighter control of their currency, and therefore, their economies. It also provided a clearer method of ascertaining the value of their currency, as opposed to the gold system which was prone to volatility and vagueness. This system contributed significantly to financial globalization.

Financial globalization has led to the integration of economies around the world, resulting in faster economic growth and development. It also increases the competition among states in pricing and quality, hence customers have a wider pool of options to choose from.

Financial globalization has been particularly crucial in developing countries because it creates employment and learning opportunities, thus facilitating higher economic growth, and reduction of poverty levels. Additionally, financial globalization necessitates the creation of more advance financial infrastructure, giving investors the benefit of access to more efficient financial systems. However, despite the numerous merits its contains, globalization also poses several demerits to the global economy. The interconnectedness of the global economy has made individual economies more vulnerable to economic crises. As exemplified by the US economic recession of 2007, a crisis in one economy has the potential of cascading down to several other economies, eventually impacting several countries. Developing countries are the worst hit since they rely heavily on trade with industrialized states for their revenues. As a

8 result of financial globalization, economies have become more competitive; as a result, investors seek out opportunities in countries that have more efficient economic systems in order to generate higher revenues (Krugman 76). This excludes countries that need the investment more, thus poor countries become poorer while rich countries become richer.

Financiailziation refers to the process by which financial institutions and systems become larger and more sophisticated in size and structure. As a result, countries generate more of their revenues from providing financial services than from the traditional trade of goods and services. The scope of financialization has increased over the years due to the realization that there are more profits to be earned from trading in financial instruments than from selling commodities. Domestic financialization is influenced by international financialization since at the domestic level, businesses and governments sometimes borrow from international financial institutions, therefore have to comply to the standards expected of these bodies (Kolb 112). Domestic financialization is to a large extent governed by international financialization because domestic bodies cannot charge higher interest rates than their international counterparts; it would affect their economies adversely.

While financialization contributes to the integration of financial sectors across the globe, its growth has been disadvantageous to the industrial sector. Financialization provides the gihest benefit to individuals, organizations and states that are already wealthy thus increasing income and wealth inequality domestically and internationally. On the contrary, industrialization benefits the entire economy by providing more employment opportunities and increasing aggregate demand. In economics, hedgehogs are institutions that view concepts from a single perspective thus tend to grow at a slower rate, while foxes are institutions that view concepts from multiple perspectives thus have the capacity to grow at a

9 faster rate. Dani Rodrik uses the term foxes to refer to economists who have varying answers to economic problems depending on the time and context (Rodrik 32). Hedgehod refers to economists who apply the same principle uniformly to all situations.

10 Works Cited Cox, J., & Tanous. Debt, deficits, and the demise of the American economy. Hoboken, N.J.: Wiley. 2013.

Kolb, R. The economics of sovereign debt. Northampton, MA: Edward Elgar Pub. 2016.

Krugman, P. Economics. CreateSpace Independent Publishing Platform. 2016.

Krugman, P. The Return of Depression Economics. Penguin Books Limited. 2015.

Newman, F. Freedom from national debt. Minneapolis, MN: Two Harbors Press, 2013.

Rodrik, Dani. The Globalization Paradox. OUP Oxford, 2014.

Salsman, R. The political economy of public debt. Northampton, MA: Edward Elgar Pub. 2017.

Wolfson, M., & Epstein, G. The handbook of the political economy of financial crises. New York: Oxford University Press. 2015.