Aiisha Kuziyeva | 25.02.2024

Fiscal Policy: Mechanisms, Advantages, and Drawbacks

Fiscal policy refers to the use of government spending and taxation to influence the economy, with the goals of managing inflation, lowering unemployment, and fostering economic growth.

Governments can increase taxes or adjust spending to implement fiscal policy. Governments may increase taxes to mitigate inflationary pressures when the economy is experiencing excessive growth to reduce consumer spending. Governments may choose to decrease taxes during economic downturns or recessions. By reducing taxes, they aim to stimulate consumer spending and business investment, thereby boosting economic activity and helping to counter the effects of an economic slowdown. The specific actions depend on the economic context and policy objectives.

Advantages of fiscal policy:

• Enabling governments to tackle economic challenges through the manipulation of demand.
• It serves as a tool for influencing economic growth, stabilizing the economy in times of decline, and addressing particular issues like unemployment or inflation.
• Facilitates an acceleration of economic growth by boosting investment rates in both public and private sectors. This occurs through strategic government spending, incentivizing private investment, and creating an environment conducive to economic expansion.
• Can encourage savings by implementing measures such as tax incentives or deductions that make saving more attractive to individuals

Disadvantages of fiscal policy:

• The effectiveness of fiscal measures can be influenced by factors like public expectations and global economic conditions, making precise outcomes challenging to predict.
• It can also cause the crowding-out effect since when the government increases its spending, it often needs to borrow money, which increases demand for loans, leading to higher interest rates. This can then discourage private sector borrowing and spending as the cost of borrowing becomes more expensive. This dynamic can result in reduced investment and consumption by the private sector.
• This can lead to decision lags due to the time it takes for policymakers to recognize economic challenges, formulate appropriate fiscal measures, and secure the necessary approvals, delaying the implementation of fiscal policies, and making it challenging to respond swiftly to changing economic conditions.