Fiscal Policy

This essay will comprehensively delve into economic theory relating directly to that of fiscal policy, its methods of implementation and consequences thereof. Fiscal policy is a method which is employed by the governments so as to stabilize the economy and steer it in a particular direction. The methods of implementation include adjustments to tax and interest rates, transfer payments and government spending. One of its main aims is to curb inflation and promote economic growth. This essay will prove, using the economic theory of Gross domestic product (GDP) and the theoretical framework surrounding it, that it was indeed advisable to increase government spending during the 2006 and 2007 financial periods. Topics to be dealt upon in this essay, contained within this framework, include that of aggregate expenditure (AE), aggregate demand (AD), Real GDP, Potential GDP and the GDP gap.

Real GDP can be defined as "the value of final goods and services which are produced in a given year when valued at constant prices. By comparing the value of the goods and service's produced at constant prices, we can measure the change in the quantity of production (PARKIN 2008). According to Parkin, Powell, Mathews, Potential GDP is the quantity of Real GDP supplied at full employment and is dependent on the full employment of labour, capital, resources and technology. When graphically analyzed, the difference between real GDP and Potential GDP is known as the GDP gap. If we were to graphically illustrate the 2006 and 2007 financial periods with that of the GDP's above, we would notice that Real GDP lies below that of Potential GDP. In economic terms this indicates the economy was in a state of recession. The graph below illustrates the business cycle during this period:

The graph depicted below illustrates real GDP less than Potential GDP:

The next concept contained within the framework is that of aggregate demand. Aggregate demand can be defined as "The quantity of real GDP demanded is the sum of the real consumption expenditure (C), investment (I), government expenditure (G), and exports (X) minus imports (M). That is :

Y = C + I + G +X - M The quantity of real GDP demanded is the total amount of final goods and services produced in a

country that people, businesses, governments and foreigners plan to buy (PARKIN 2008) Below are graphs illustrating aggregate demand and changes in aggregate demand respectively :

One of the main factors that influences buying plans, other than price, is fiscal policy and it in turn brings about a change in aggregate demand (illustrated above).

An implementation of fiscal policy by means of reducing taxes or increasing government spending or increasing transfer payments will all have the same effect. It will increase aggregate demand as all the above mentioned influences result in increasing the households' disposable income ( aggregate income minus taxes plus transfer payments ). " The greater the disposable income, the greater is the quantity of consumption goods and services that households plan to buy and the greater is aggregate demand." (PARKIN 2008). However, an increase in aggregate demand would realistically result in an increase in production which would ultimately result in an increase in Real GDP. An increase in real GDP would result in higher incomes and with this new higher income comes even greater demand and so on and so on. This whole process is known as the multiplier effect and it can be calculated with the following formula :

Multiplier