Fiscal policy generally refers to the use of taxation and government expenditure to regulate the aggregate level of economic activity. Thus, if unemployment is regarded as too high, income and expenditure taxes may be varied to stimulate the level of aggregate expenditure (demand).
The overall effect on economic activity will depend on the size of the tax cut and the value of the multiplier. Increasing government expenditure will raise the level of activity by an amount equal to the change in expenditure times the fiscal multiplier.
It is a coefficient that indicates by how much an increase in fiscal expenditure affects the equilibrium level of income.
For example, in the simple Keynesian model:
Y = C + I + G
C = a + bY
I = I
G = G
The equilibrium value for income, Y is:
Y = (1/1 – b) (a + I + G) = αA
where A is autonomous expenditure and a is the fiscal multiplier. The advocates of fiscal policy argue that the changes in taxation together with transfer payments proportional to the existing distribution of income are the appropriate weapons to regulate aggregate activity and control business (trade) cycles.
The use of fiscal policy entails changes in the government’s budget including the possibility of deficits. The conventional view is that the use of deficit finance in this situation is perfectly proper though attention has to be given to the impact of this as well.
Thus fiscal policy is a tool of general macroeconomic policy that seeks to influence the level of economic activity through the control of government expenditure and taxation.
Keynes advocated the use of deficit financing (that is, a budgetary deficit where the government spends more than its revenue from taxation) in the 1930s to effect a transition from a situation of mass unemployment to one approaching full employment.
Keynes argued that an increase in government spending or reduction in taxes (an injection into the economy) stimulates aggregate demand via the multiplier effect, thus, creating jobs and increasing output (GNP) to satisfy that demand, raising national income (from Y0 to Y1).
If, on the other hand, the level of economic activity is too high, the government enjoys the option of running a budgetary surplus, decreasing its expenditure or increasing taxes (a leakage from the economy) to reduce aggregate demand.
The main aim of fiscal policy is to effect a countercyclical policy, so that booms and depressions during the course of the business cycle are fully neutralised. However, modem economists feel that fiscal policy is more suited to the conditions of depression that existed when Keynes wrote his General Theory than to inflationary economies.
Consequently, in the late 1970s economists lost faith in fiscal policy. There was a shift of emphasis on monetary policy which was directed toward achieving economic stability, i.e., full employment growth along with price level stability.
Quite recently there has been a renewed emphasis on fiscal policy. Fiscal policy is now being received with more credibility than was given to it in the late 1970s. However, the debate still continues as to the most effective stabilising policy instruments to use.