Politics and Fiscal Policy

Monty Douglas

November 28, 2010

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BA206 Macroeconomics

Politics and Fiscal Policy

Suppose that fiscal policy changes output faster than it changes the price level. How might such timing play a role in the theory of political business cycles A political business cycle is a business cycle that results primarily from the manipulation of policy tools (fiscal policy, monetary policy) by incumbent politicians hoping to stimulate the economy just prior to an election and thereby greatly improve their own and their partys reelection chances. Expansionary monetary and fiscal policies have politically popular consequences in the short run (tax cuts, falling unemployment, falling interest rates, new government spending on services for special interests, etc.). Unfortunately these very policies, especially if pursued to excess, can also have very unpleasant consequences in the longer term (accelerating inflation, an unsustainably low rate of savings to support future investment, damage to the foreign trade balance, long-term expansion of governments share of the GNP at the expense of peoples disposable incomes, etc.). So immediately after the election is over (and the next election is far away), politicians tend to ???bite the bullet??? and reverse course by raising taxes, cutting spending, slowing the growth of the money supply, allowing interest rates to rise, etc. Thus the regular holding of elections tends to produce a boom-and-bust pattern in the economy because of the on-again-off-again pattern of government stimulus and restraint encouraged by trying to schedule an artificial boom at every election time.

Is this a valid role for fiscal policy Yes, given the effects of fiscal policy, particularly in the short run, we should not be surprised that elected officials might try to use it to get reelected. The link between economic performance and reelection success has a long history. Ray Fair of Yale University examined presidential elections dating back to 1916 and found, not surprisingly, that the state of the economy during the election year affected the outcome. Specifically, Fair found that a declining unemployment rate and strong growth rate in GDP per capita increased election prospects for the incumbent party. Clearly, a weak economy in 2008 helped Barack Obama defeat the incumbent party candidate, John McCain.

?  Another Yale economist, William Nordhaus, developed a theory of political business cycles? , arguing that incumbent presidents, during an election year, use expansionary policies to stimulate the economy, often only temporarily. For example, evidence suggests that President Nixon used expansionary policies to increase his chances for reelection in 1972, even pressuring the Federal Reserve chairman to pursue an expansionary monetary policy.

Fiscal policy is that part of government policy which is concerned with raising revenue through taxation and with deciding on the amounts and purposes of government spending. Keynesian economic theorists believe that government can, and should, regulate the overall pace of activity in the national economy through fiscal policy, principally by deliberately having government borrow to spend more than it takes in (running a budget deficit) to increase total demand for goods and services in times of high unemployment and economic slowdown (the deficit being created either by cutting taxes or by increasing spending or both). Similarly, Keynesian theorists would advocate having government spend less than it takes in (running a budget surplus) to cool down the national economy when too great an expansion of total demand has pushed production to its physical limits and threatens to bring on excessive inflation.
The surplus causes the market price of good or service to fall and suppliers cannot sell what they want. Suppliers respond to the surplus by continuing to lower prices until the market reaches equilibrium. Lowering price increases quantity demanded and decreases quantity supplied. However, when there is a shortage in quantity supplied market price falls below the equilibrium price. The economy fluctuations in today??™s world have become one of the most important factors in determining the direction of an economy growth. Non-stable economy can harm and slow the development and growing rate of a nation. There are many tools to stabilize the economy and reduce the frequency and the altitude of economic fluctuations. Among these tools are the fiscal policy and monetary policy. This report discusses the fiscal policy and why the governments use this too to stabilize the economy and encounter the economic fluctuations. Definition Fiscal policy is a macroeconomic tool used by the government through the control of taxation and government spending in an effort to affect the business cycle and to achieve economic objectives of price stability, full employment and economic growth.



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