Question

How is fiscal policy used to address problems in the economy? How are the short run and long run consequences of using fiscal policy different? What are the issues that complicate the task for policy makers of using fiscal policy to manage the economy?

Answer 1

Fiscal policy means increasing or decreasing the government expenditure and taxes to stimulate the demand in the economy. In case of a recession or high level of unemployment, the government will introduce a deficit budget i.e. increased government expenditure. And in case of high inflation in the economy, the government can introduce a surplus budget.

In the short run, a deficit government budget increases the demand in the economy because in the short run the supply curve is upward sloping it will cause a small crowding out. In the long run, the long run supply curve is a straight vertical line. Any increase in the government expenditure will have a 100% crowding out effect and will not influence the economy at all.

Issues that complicate using fiscal policy to manage economy are:

• Crowding out effect: Too much fiscal expenditure discourage the private spending in the economy.
• Government debts: If the government is running a deficit it will most likely increase the inflation in the economy or it will increase the taxes and subdue demand. Increasing debt will just pass the burden on the coming generation.