Fiscal Policy
Authors: Gabriel Angelo C. Abuel, Jose Benjamin J. De la Cruz, Maria Angela T. Tabago, Naomi Chyla G. Choo
Fiscal Policies are measures employed by the government to influence a country’s economic conditions to foster stability, promote growth, and reduce poverty (Britannica, 2022; Horton & El-Ganainy, n.d.). These policies are done through the use of government funds or the regulation of taxes. For example, the government could lower tax rates or increase government expenditures to boost economic activity during an economic recession. On the other hand, the government can increase taxes while cutting its spending to slow down the economy and stall inflation (Hayes, 2022).
It is important to understand fiscal policy because it acts as a tool that the government utilizes to balance the economic conditions within a country (Hayes, 2022). These measures can affect everyone. Changes in the government budget and taxation could be felt by us consumers. For example, tax cuts can be beneficial for families because they would have more disposable income (Weil, n.d.). This concept could also help us better understand how the government acts during times of economic recession, rise in inflation, or any global economic crisis. For the next part, we’ll learn about the two types of fiscal policy, and how they influence consumption, investments, and inflation, among other things.
Types of Fiscal Policy
There are two types of fiscal policy: contractionary and expansionary. Contractionary fiscal policy is used to slow economic growth in case of inflation growing rapidly. This policy is implemented by raising taxes to cut public spending. Since consumers pay more taxes, they will have less money to spend, thereby leading to slower economic growth (Kuligowski, 2022). In addition, less disposable income will decrease demand from businesses. Once demand decreases, businesses will stop raising prices, leading to a lower rate of inflation (Boyce, 2022). This policy can also be implemented through a decrease in government spending. Since the government purchases fewer goods and services from the private sector, there will be slower economic activity (Weinstock, 2021). This type of fiscal policy is also characterized by budget surpluses (Hayes, 2022). A budget surplus is when government revenues exceed government spending.
Expansionary fiscal policy, on the other hand, is designed to stimulate and boost the economy. It is often used during times of high unemployment and recession. This is implemented by the government through an increase in government spending or lowering of taxes or both. As more money is put in the hands of the consumers, they are able to spend more and stimulate the economy (Kuligowski, 2022). Increased government spending can also boost the economy since it increases aggregate demand. For instance, a new government project can create jobs for people who are otherwise unemployed. As these people gain more money, they will be able to spend more and thus, stimulate the economy. This impact of government spending on private spending is called the multiplier effect. In contrast to budget surpluses in contractionary fiscal policy, expansionary fiscal policy is characterized by deficit spending. Deficit spending occurs as a result of greater government spending than revenues from taxes and other sources (Hayes, 2022).
Aside from increasing or decreasing demand, fiscal policy can also affect the exchange rate and trade balance. For instance, a fiscal expansion may require the government to borrow more money to fund their greater spending. Because the government competes with private sector investments for the people’s limited savings, interest rates tend to rise. This could then increase the influx of foreign capital due to better returns, which also pushes up demand for the country’s currency. The attempt to get more foreign investments can cause an exchange rate appreciation in the short run (Weil,n.d.). Changes in a currency’s value will affect trade, as exports and imports will become relatively more expensive or cheaper. For more information on exchange rates and trade, you may read the FinLit on exchange rates on UPIC’s website.
How fiscal policy stabilizes the economy during the phases of the business cycle
Fiscal policy is very important in managing the economy because it can affect the nation’s Gross Domestic Product (GDP) or the total value of final goods produced within the country. As previously mentioned, fiscal expansion increases aggregate demand, which leads to an increase in the production and prices of goods and services. The degree of increase will, however, depend on the state of the business cycle, among other factors. If the economy is in a recession where there is unemployment, the increase in demand will most likely increase output but not price. In the case of full employment, fiscal expansion will have more impact on prices than total output (Weil, n.d).
Fiscal policy’s ability to influence output allows it to become a tool for economic stabilization. During a recession, when the government implements an expansionary fiscal policy, the output is brought to a normal level and the level of unemployment decreases due to the creation of more jobs. In the case of a boom, inflation becomes the main problem and so the government implements a contractionary fiscal policy and runs a budget surplus, slowing down the economy. Such countercyclical policies lead to a balanced budget (Weil, n.d.).
Indeed, instead of letting the market correct itself, the government has fiscal policy tools that can stabilize business cycles and regulate economic output (Hayes, 2022).
Effects of fiscal policies on the stock market
The effects of fiscal policy can spill over to the stock market as factors such as employment and aggregate demand are affected. As part of the multiplier effect, if the policy is expansionary to combat a recession, the resulting increase in the demand for goods and services could mean better sales figures and revenues for companies. This could translate to improvements in important metrics such as the EPS (earnings per share) and EBITDA (earnings before interest, taxes, depreciation, and amortization), which are often looked at in fundamental analysis. More favorable values in a company’s financial statements can potentially raise its stock price as investors gain confidence in its performance.
However, it must be stressed that expansionary fiscal policy does not have a guaranteed positive effect on the stock market. Neither will contractionary fiscal policy result in losses in the stock market. It all depends on how suitable the government policy is to the current economic situation. Since fiscal policy is usually intended as a stabilizer to get the GDP close to its potential, or the level of output that is most sustainable, both contractionary and expansionary policies may be beneficial to investors depending on how and when they are applied. For example, an overheating economy which still has an expansionary policy might be unstable. Inflation is high, growth is unsustainable, and the economy may be sensitive to shocks and asset bubbles. Increased risk along with a lack of appropriate government intervention could foment negative investor sentiment and drive down demand for the stocks of companies within that country in general. With that said, nothing is ever guaranteed by these policies since their effect on the stock market is indirect. Fiscal policies alone should not be used as an indicator for movements in the stock market, but could be a useful supplement in determining the underlying strength of a country’s economy and the health of its industries.
Conclusion
Governments use fiscal policy as a tool to influence economic conditions, promote sustainable growth and stability, and lessen poverty. It is significant because it serves as a tool for the government to balance the nation's overall economic conditions. There are two types of fiscal policy: contractionary and expansionary. When inflation is rising too quickly, a contractionary fiscal policy is used to slow economic growth. On the other hand, expansionary fiscal policy is frequently used when there is a recession and high unemployment because it is intended to stimulate and boost the economy.
Fiscal policy helps stabilize the economy during the business cycle’s various phases. As it affects employment and aggregate demand, it also has an impact on private spending, which can then affect the stock market through companies’ revenues and other metrics. However, because fiscal policy’s effect on these companies is mostly indirect, it is not an indicator of stock prices in itself but could be used as an additional tool to gauge fundamental macroeconomic stability.
References
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https://www.britannica.com/topic/fiscal-policy
Hayes, A. (2022, July 28). All About Fiscal Policy: What It Is, Why It Matters, and Examples.
Investopedia. Retrieved from https://www.investopedia.com/terms/f/fiscalpolicy.asp
Horton, M. & El-Ganainy, A. (n.d.). Fiscal policy: taking and giving away. International
Monetary Fund. Retrieved November 2, 2022, from https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Fiscal-Policy#:~:text=Fiscal%20policy%20is%20the%20use,sustainable%20growth%20and%20reduce%20poverty
Kuligowski, K. (2022, August 23). What is Fiscal Policy? Business News Daily. Retrieved from
Weil, D. (n.d.). Fiscal Policy. Econlib. Retrieved from
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