Question

Expansionary Fiscal Policy funded by government borrowing is the current administration's strategy for addressing economic growth. What is your opinion of this policy from an economic point of view? What risks are associated with this policy? What must the Central Bank do to allow this policy to succeed?

Answer 1

Ans.

The current expansionary policy, funded by government debt is trying to improve the growth and is being done through the following forms :
Cuts in personal income tax raise disposable income with the objective of boosting aggregate demand
Cuts in sales (indirect) taxes to lower prices which raises real incomes with the objective of raising consumer demand
Cuts in corporation (company) taxes to boost business profits, which may raise capital spending.
Cuts in tax rates on personal savings to raise disposable income for those with savings, with the objective of raising consumer demand
New public spending on social goods and infrastructure, such as hospitals and schools, boosting personal incomes with the objective of raising aggregate demand
After the credit crisis of 2008, government actively stimulate economy through increased expenditures without raising taxes and revenues. This has led to increased borrowing which has become a concern in the financial markets.
If the ratio of debt to GDP rises beyond a certain unknown point, then the solvency of the country will come into question.
An additional indicator for potential insolvency is the ratio of interest rate payments to GDP, Such ratios could rise rapidly with the growing debt ratios of 2009 and 2010.
If an economy grows in real terms, so do the real tax revenues and hence the ability to service a growing real debt at constant tax rate levels.
However, if the real growth in the economy is lower than the real interest rate on the debt, then the debt ratio will worsen even though the economy is growing because the debt burden grows faster than the economy.
Hence, an important issue for governments and their creditors is whether their additional spending leads to sufficiently higher tax revenues to pay the interest on the debt used to finance the extra spending.
However please note that the reliability and magnitude of these relationships will vary over time and from country to country.

Indeed, in very general terms economists are often divided into two camps regarding the workings of fiscal policy: Keynesians believe that fiscal policy can have powerful effects on aggregate demand, output, and employment when there is substantial spare capacity in an economy. Monetarists believe that fiscal changes only have a temporary effect on aggregate demand and that monetary policy is a more effective tool for restraining or boosting inflationary pressures. Monetarists tend not to advocate using monetary policy for countercyclical adjustment of aggregate demand. This intellectual division will naturally be reflected in economists’ divergent views on the efficacy of the large fiscal expansions observed in many countries following the credit crisis of 2008, along with differing views on the possible impact of quantitative easing.
In a recession, governments can raise spending (expansionary fiscal policy) in an attempt to raise employment and output