Economic Steering Tools: Government's Role in Economy Direction - Classifications, Consequences
Unscripted Fiscal Policy Action: A Government's Deliberate Move to Steer the Economy
Unscripted fiscal policy action, in essence, is a strategic move taken by the government to influence the economy's direction using carefully planned changes in spending and income. Here, we'll delve into the workings of this deliberate policy, its impact on the economy, and the various tools governments deploy to navigate the economic ship.
What's the Deal with Unscripted Fiscal Policy?
Unscripted fiscal policy is a conscious policy used by the government to change the economy by altering its income and expenditure. It's intentional since the government aims to steer the economy towards the desired state, and this requires changing the budget. The new budget necessitates approval or a vote to be executed.
These adjustments significantly affect aggregate demand, ultimately determining economic growth, inflation, and unemployment rates. For instance, increased government spending directly impacts aggregate demand, while changes in taxes influence government revenues and private sector consumption and investment. The policy's objective is to stimulate or moderate economic growth, as needed.
Unscripted vs. Non-Unscripted Fiscal Policy
The key difference between the two lies in the level of involvement required. Unscripted fiscal policy demands governmental action to change its budget in order to stabilize the economy and ward off negative consequences such as sudden inflation spikes or recessions.
These budget modifications necessitate specific actions before implementation, such as changing tax laws, and securing approval in parliament.
On the other hand, non-unscripted fiscal policy (often referred to as automatic stabilizers) functions automatically – sometimes, we call it a self-stabilizing mechanism. Certain government spending and income levels rise or fall with the economic cycle, but they work counter-cyclically, and their effect is inversely related to the economic cycle.
For example, unemployment benefits increase during a recession when the unemployment rate rises, yet they decrease during an economic expansion when the unemployment rate falls. Unlike unscripted policies, automatic stabilizers don't require explicit government intervention.
Unscripted Fiscal Policy's Impact on the Economy
Unscripted fiscal policy affects the economy through its influence on aggregate demand, defined as the sum of household consumption, business investment, government spending, and net exports. Changes in aggregate demand impact the economy's output indicators, such as inflation and unemployment rates.
For instance, increased government spending results in enhanced aggregate demand, which triggers an increase in the price level (upward inflationary pressure). This price increase encourages businesses to expand productivity, hire more labor, or implement overtime to boost output. Greater output translates into additional income and jobs within the economy, prompting households to increase consumption. This, in turn, augments aggregate demand.
Stronger aggregate demand precipitates an increase in the price level, leading businesses to boost output even further. They're likely to invest more because production capacity has reached its maximum and they've hired more workers. In conclusion, increased government spending leads to higher economic growth due to stronger aggregate demand, resulting in increased inflation and reduced unemployment.
Tax adjustments similarly affect aggregate demand but not directly. Its increase or decrease impacts the available dollars for consumption and savings. For example, a decrease in taxes translates to an increase in disposable income, making more dollars available for spending. This encourages households to increase consumption, in turn boosting aggregate demand.
Practical Examples of Unscripted Fiscal Policy
To effect change, the government must alter its items in the budget, employing two primary tools: government spending and taxation. These modifications require approval from the president and parliament or changes to related laws and regulations.
For example, the government increases the infrastructure budget to build roads, bridges, and ports. This increases demand for goods and services within the economy, stimulating overall economic activity.
Taxation serves as the second tool. The government may use higher rates to moderate aggregate demand, or, conversely, cut tax rates to spur economic growth. Changes in taxation are enacted through new legislation.
Aims of Unscripted Fiscal Policy
The primary goal of unscripted fiscal policy is to stabilize the economy, moderating fluctuations in the output gap (see macroeconomic equilibrium). It works to stimulate economic growth during a recession and moderate the inflation rate and economic growth during expansion.
During an economic overheating phase (called the economic boom), the economy may operate above its potential output (positive output gap), leading to high inflation that disrupts the economy's stability. If left unaddressed, inflation can spiral out of control, culminating in dangerous hyperinflation, which quickly erodes the purchasing power of money.
On the other hand, during recession periods, the government grapples to stimulate recovery. Increased government spending and reduced taxes can stimulate economic growth, but during these periods, the private sector may lack the strength to lift the economy out of recession.
Types of Unscripted Fiscal Policy
Based on the objective, there are two main forms of unscripted fiscal policy:
- Expansionary policy: intends to stimulate economic growth by increasing aggregate demand and reducing taxes or increasing government spending. During periods of weakness or recession, this policy, sometimes called loose fiscal policy, is adopted.
- Contractionary policies: target economic overheating situations where the economy is operating above its productive capacity (real GDP exceeds potential GDP), causing persistent inflationary pressures. The government takes measures to moderate aggregate demand, leading to a decrease in economic growth.
Both approaches aim to stabilize the economy but have opposite effects on aggregate demand. Expansionary policies aim to increase aggregate demand and subsequently stimulate economic growth, whereas contractionary policies aim to moderate aggregate demand and inflationary pressures, resulting in weaker economic growth.
In the case of expansionary policies, the government takes one or more of the following actions to invigorate economic activity:
- Reduced taxes
- Increased spending
By cutting taxes and increasing spending, the government often incurs a budget deficit. Lower taxes mean less revenue, while increased spending means higher costs. However, these steps can augment demand, leading to increased prices and employment.
Infrastructure projects, such as road, bridge, and port construction, are cases of increased spending. This spending creates demand for goods and services, stimulating overall economic activity. Additionally, infrastructure spending creates both direct and indirect jobs, such as construction-related work, revenue generation, and consumption.
Conversely, during economic overheating periods (the final phase of expansion), the government implements contractionary policies, also known as tight fiscal policy. To control the surge in inflation, the government takes steps to reduce aggregate demand through increased taxes or decreased spending. This weakens demand, easing inflationary pressures, and curbing economic growth, thereby preventing hyperinflation. However, if implemented too aggressively, contractionary fiscal policies can cause an economic contraction, where aggregate output falls, leading to deflation, and higher unemployment.
Resources to Explore Further
- Government Budget: Balancing Revenue, Spending, and Fiscal Policy - Components, Impacts
- Cyclical Budget Deficit: Why It Matters and How It Works - Causes, Impacts
Unscripted Fiscal Policy Influences:
- Economic Growth: Unscripted fiscal policy promotes economic growth by stimulating demand through increased government spending on infrastructure, public services, or investment, creating jobs and boosting incomes, leading to a multiplier effect that increases overall GDP. Conversely, reduced spending or increased taxes can slow economic activity and control inflation or reduce deficits, potentially lowering growth.
- Unemployment Rates: Fiscal policy can affect unemployment rates by increasing jobs through increased government spending or tax cuts, leading to higher aggregate demand and stimulating economic activity. Conversely, contractionary fiscal policies aim to moderately slow down demand to address periods of overheating or fiscal consolidation, potentially increasing unemployment.
- Unscripted fiscal policy can impact the business sector by directly altering government expenditure, particularly in infrastructure projects that require goods and services provided by private companies.
- Financial institutions and corporations alike appreciate well-timed unscripted fiscal policy, as it helps maintain the economy's balance and stabilizes inflation rates, fostering a conducive environment for long-term investments and growth.
