To drive the economy in the right direction and ensure growth, the government implements fiscal policy, which is a crucial part of economics. The fiscal policy emanates from the theories of John Maynard Keynes, the British economist, that states that factors like changes in government revenue or taxes and spending directly impact employment, inflation, and the flow rate of money through the economic system. Paul Haarman observes that in any economy, fiscal policy and monetary policy work hand in hand. In the United States, the Federal Reserve or The Fed takes the policy decisions that influence the direction of the economy and realize the economic goals.
The fiscal policy plays a critical role in managing the economy successfully since it impacts the factors like inflation, spending, taxes, and employment, which all contribute to the GDP or the Gross Domestic Product, which represents the value of the services and goods produced by a country during the year.
The impact of fiscal policy on the economy explained by Paul Haarman
To understand the impact of fiscal policy on the economy, let us look at an example. Whenever there is a fiscal stimulus or fiscal expansion, it results in rising demand, which pushes up production. If the increase in demand occurs in an economy of high employment, it will lead to variations in prices. However, the scenario in a low employment economy will be quite different as the demand will boost production and employment but might not result in price variation. Whether the GDP will change or not depends on the prevailing situation.
Factors that contribute to economic success
GDP is one of the many factors used to measure the success of the economy. Aggregate demand is another factor which is the total of the goods and services produced by a country procured at a certain price point. On looking at the aggregate demand curve, you can easily understand that the demand for goods and services goes up when the price levels are low, and the opposite happens when the price levels are high.
The fiscal policy directly impacts these factors, and by adjusting the fiscal policy according to the prevailing economic situation, it is possible to increase the aggregate demand and the GDP in a sustainable manner, confirming Paul Haarman. He goes on to explain in detail the impact of the change by tweaking the factors like business tax policy, government spending, and individual taxes.
Business tax policy
Businesses calculate profits in two stages – profit before tax and profit after tax. This gives business owners an idea about the impact of taxes on profitability. The taxes imposed by the government impacts not only profits but also investments. When taxes are low, it increases business spending through investment and increases aggregate demand.
Governments can increase the aggregate demand by increasing their own spending. Hence, government spending is an imprtant aspect of fiscal policy.
The spending ability of individuals depends largely on the level of income tax they pay as it affects their personal income. More public spending injects more money back into the economy.
The fiscal policy needs frequent adjustments to improve and control the economy.