Question

Discuss the economic basis for Fiscal Policy and the tools for its application. Your answer should include the following elements:

What economic circumstances gave rise to the Keynesian approach to understanding the workings of the economy?

What are the principal differences between the Keynesian and Classical approaches to understanding the workings of the economy?

What economic challenges is Fiscal Policy designed to address?

What are the tools used in implementing Fiscal Policy?

What are the challenges inherent in ensuring that Fiscal policy is effective?

Answer 1

What economic circumstances gave rise to the Keynesian approach to understanding the workings of the economy?

Classical economics failed to address the issues of economy and its prescription could not create employments during the recession. Aggregate demand was too low to increase output and employment. Thus, Keynese developed separate theory explaining basic cause behind the recession and unemployment.

What are the principal differences between the Keynesian and Classical approaches to understanding the workings of the economy?

Classical economists consider that full employment is general condition in economy. Flexible wages and prices lead to automatic restoration of full employment. Other side, keynese does not agree with classical explanation of recession and strongly recommend active participation of government in driving up aggregate demand in economy.

What economic challenges is Fiscal Policy designed to address?

Fiscal policy is designed to drive up aggregate demand when economy faces recession and reduce demand when economy faces the boom.

What are the tools used in implementing Fiscal Policy?

Tax and expenditure are tools of fiscal policy. Government changes in tools frequently to change direction of economy.

What are the challenges inherent in ensuring that Fiscal policy is effective?

Crowding out effect reduce the effectiveness of fiscal policy. Spending by the government drives up interest rate and higher interest rate discourages private investment.

Furthermore, internal lag effects are larger in fiscal policy. Thus, economic conditions might get changed by the time government take actions to correct depressed demands.