Question

3.

a. What are the tools of Fiscal Policy?

b. Explain how government expenditure crowds out private investment.

c. Explain various components of government expenditure, and challenges the government faces to meet those expenditure each year.

Answer 1

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Definition

Fiscal policy is a crucial part of American economics. Both the executive and legislative branches of the government determine fiscal policy and use it to influence the economy by adjusting revenue and spending levels

A) Tools of Fiscal Policy

1.Budget

The budget of a nation is a useful instrument to assess the fluctuations in an economy.

Different budgetary principles have been formulated by the economists, prominently known as:

(1) Annual budget,

(2) cyclical balanced budget and

(3) fully managed compensatory budget.

2.Taxation

Taxation is a powerful instrument of fiscal policy in the hands of public authorities which greatly effect the changes in disposable income, consumption and investmen

3.Public Expenditure

The active participation of the government in economic activity has brought public spending to the front line among the fiscal tools. The appropriate variation in public expenditure can have more direct effect upon the level of economic activity than even taxes.

4.Public Works

They include expenditures on public works as roads, rail tracks, schools, parks, buildings, airports, post offices, hospitals, irrigation canals etc.

B.Government expenditure crowds out private investment

When the economy is operating near capacity, government borrowing to finance an increase in the deficit causes interest rates to rise. Higher interest rates reduce or “crowd out” private investment, and this reduces growth. ...

The extent to which interest rate adjustments dampen the output expansion induced by increased government spending is determined by:

• Income increases more than interest rates increase if the LM (Liquidity preference—Money supply) curve is flatter.
• Income increases less than interest rates increase if the IS (Investment—Saving) curve is flatter.
• Income and interest rates increase more the larger the multiplier, thus, the larger the horizontal shift in the IS curve.

In each case, the extent of crowding out is greater the more interest rate increases when government spending rises.

C. components of government expenditure

following are the main components of government expenditure :

1. Mandatory/entitlement spending

Mandatory spending include:

• Social Security: Financial support for the elderly.
• Healthcare: Medicare (health insurance for the elderly) and Medicaid (health insurance for low-income individuals).
• Income Security: Disability Assistance, Food and Nutrition Assistance, Supplemental Security Income, Earned Income Tax Credits, and Child Tax Credits.
• Veterans Benefits: Income Security for Veterans and Healthcare Assistance.
• Other: Agriculture, Energy, General Government Services, and International Affairs.

2.Discretionary spending

Discretionary spending includes:

• Defense: Spending attributable to the maintenance and strengthening of the United States Armed Forces.
• Non-defense:
  • Transportation: Road improvements and repairs, air traffic control, Amtrak and other infrastructure investments.
  • Education: K-12 education grants, school choice programs, disability and special education programs, and lunch assistance.
  • Other veterans' benefits.
  • Public health, law enforcement, natural resources, and science.
  • Housing assistance and community services.
  • Foreign affairs and other expenditures.

3.National defense spending

National defense spending is any government spending attributable to the maintenance and strengthening of the United States Armed Forces, including the Army, Navy, Marines, and the Air Force.

Challenges the government faces to meet those expenditure

1.Inaccuracy

Unless management acts quickly to override the budget, managers will continue to spend under their original budgetary authorizations, thereby rupturing any possibility of earning a profit

2.Rigid Decison Making

The budgeting process only focuses the attention of the management team on strategy during the budget formulation period near the end of the fiscal year.

3.Time required.

It can be very time-consuming to create a budget, especially in a poorly-organized environment where many iterations of the budget may be required.

4.Expense allocations.

The budget may prescribe that certain amounts of overhead costs be allocated to various departments, and the managers of those departments may take issue with the allocation methods used.

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