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Fiscal policy has the primary goal of stimulating the economy using government expenditure and taxation. Fiscal policy is different from other macroeconomic policies such as macroeconomic policies, which stabilize the economy using interest rates and monetary policies that stabilize the economy by controlling currency supply (Guillermo and Rodrigo 125). The tools of fiscal policy rely significantly on government expenditure and taxation. Adjustments in these variables impose significant effects on economic variables such as aggregate demand, resource allocation and patterns of income distribution. The primary objective of fiscal policy is to manipulate the government budget to achieve its economic goals and objectives. Fundamentally, the fiscal policy helps the government to manipulate Gross Domestic Product, inflation and employment rates, and economic growth and development through maintaining a balance between government taxation and expenditure (McConnell, Brue and Flynn 257). The government can adopt neutral, expansionary or contractionary fiscal stances to stimulate the economy. An expansionary policy entails a higher government expenditure relative to tax revenues, while a contractionary fiscal policy entails a higher tax revenue relative to government expenditure. The government can use various components of fiscal policy to stimulate the economy depending on its fiscal stance. This paper focuses on one component of fiscal policy, the crowding-out effect, and how this component of fiscal policy works.

Crowding-Out Effect

Crowding out refers to the broad effects associated with expansionary fiscal policies. Crowding out takes place when an expansionary fiscal policy leads to an increase in interest rates, which in turn reduces private investment spending. This implies that an increase in government expenditure serves to crowd-out private investment spending (McConnell, Brue and Flynn 273). Deficit spending compels the federal government to embark on increased borrowing in order to finance the budget deficits and refinance the debt. The outcome of such an expansionary policy is an increase in the interest rate and a decline in investment spending, which in turn weakens the stimulus of the expansionary fiscal stance. The increasing interest rate has the potential of crowding out interest-sensitive consumption spending. Because investment is the most unstable constituent of Gross Domestic Product, crowding out places emphasis on investment and determining whether an offsetting cut in investment can partly or fully neutralize the stimulus due to deficit spending.

Deficit spending compels the government to borrow money, which in turn increases the general demand for money. On the assumption that monetary authorities are keeping the currency supply constant, the increase in demand for money has the potential of increasing the interest rate, which is the price paid for borrowing money. Economists have varied opinions regarding the effectiveness of the crowding-out effect. It is imperative to take note that the crowding-out effect does not impose negative impacts during cases of recession because of the reduction in investment demand (McConnell, Brue and Flynn 274). This is because output purchases slow down during times of recession; as a result, most enterprises remain with considerable excess capacity. With the investment demand weakening during times of recession, the effect of crowding-out is likely to be small. This is because there is inadequate investment for the government to choke-out. Even in cases where deficit spending increases the interest rate during a recession, the effect on investment may be fully offset by the improved investment prospects that enterprises anticipate from the fiscal stimulus. On the contrary, when the economy is at full capacity, the investment demand is considerably strong; implying that crowding out imposes a significant problem. When the economy booms, businesses will be operating at full capacity and enterprises will have high investment demand for two primary reasons. First, factory equipment will be running at full capacity, leading to fast wearing out; implying that firms will invest considerable amounts. Secondly, the firms will increase their production in order to exploit the anticipated demand for their produce. It is apparent that the crowding-out effect points out that an expansionary fiscal action has the potential of increasing the interest rate and reducing private investment spending (Guillermo and Rodrigo 156).       

A potentially significant problem is the continued financing of large public debts because it can transfer the real economic burden to coming generations via smaller stock of capital goods. This is due to the notion that public borrowing increases real interest rates, which in turn condenses private investment funding. If government borrowing took place only during recessions, then crowding out would not be of a significant concern. Since investment demand is usually weak during recessions, implying that rising interest rates initiated by public borrowing will only lead to a minimal reduction in private investment spending. On the contrary, the need to fund a large public debt continuously can turn out to be troublesome. There are some cases where financing requires the government to borrow large amounts money when the economy is operating at a full employment output (McConnell, Brue and Flynn 275). Since this takes place when private investment demand is strong, any increase in interest rates based on borrowing to refinance the public debt can impose substantial reduction in investment spending. Extensive crowding out of private investment implies that coming generations will operate under an economy having a smaller production capacity, resulting to a low standard of living.

It is apparent that private investment spending is inversely related to the real interest rate; this is evident in the investment demand curve shown below. On the assumption that public borrowing raises the interest rate from 6 to 10%, private investment spending will reduce from $25 billion to $ 15 billion; therefore, the economy will shift from a to b. This is to say, financing the public debt will compete with the financing of private investment and choke out $ 10 billion worth of private investments. The implication is that private capital transferred to future generations will be less by $10billion than it would have been devoid of the need to finance public debt. However, in cases whereby public goods facilitated by the debt stimulate the prospects of investment, there will be rightward shift of the investment demand curve from ID1 to ID2. The shift may serve to offset the crowding-out effect partly or fully, in which case the economy moves from a to c.

 Conclusion

The paper has established that crowding out is of less concern during times of recession; however, it may impose significant problems when the economy is operating at full capacity. Since private investment is the most unstable constituent of GDP, crowding out places emphasis on investment, and whether an offsetting cut in investment can partly or fully neutralize the stimulus due to deficit spending. This is due to investment prospects in business that results from the economic stimulus initiated by the fiscal policy action.

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