ECONOMIC ANALYSIS

MIDTERM EXAM

WHAT IS FISCAL POLICY

1. Fiscal Policy comprises decisions made by the government on revenue
collection and spending in order to influence the economic activity of the
country. Based on the work of John Maynard Keynes, taxes and government
spending are adjusted to improve unemployment rates, control inflation rate,
and increase or decrease income.
a. Actually, there are two forms of Fiscal Policy the Expansionary Fiscal
Policy and the Contractionary Fiscal Policy, which have opposing effects on
the economy. In Expansionary Fiscal Policy, taxes are reduced,
government expenditures are increased, and transfer payments are
augmented. In turn, these measures affect the economy by increasing
aggregate demand, thereby stimulating GDP growth or economic growth.
On the other hand, Contractionary Fiscal Policy has the inverse effect to
the economy. Taxes are increased, government spending is reduced, and
transfer payments are decreased. These measures in turn, dampen
economic activity by decreasing aggregate demand and national income.
b. However, a possible ill side effect in the implementation of fiscal policy
particularly Expansionary Fiscal Policy, is that it could cause crowding
out of the private sector. Crowding out creates at least three problems.
First, an expansionary fiscal policy means that the government is using
financial resources that are now longer available for use by individuals and
businesses. If the spending is financed through raising revenue through
taxation, then that means there will be fewer dollars in the pockets of
individuals and businesses to use for spending and investment.
Additionally, if the government is competing for goods and services along
with individuals and business, it may result in increased prices because of
the increase in demand. The problem may be compounded if the
government finances its spending through borrowing. The sheer size of a
government's borrowing may create upward pressure on interest rates as
the private sector and public sector compete for loans. This will make
financing more expensive, which will have a negative effect on private
economic growth. If it costs too much to obtain financing, individuals will
decide not to purchase and businesses will decide not to invest.
c. The main source of funding of the government in the implementation of
Fiscal Policy is from tax revenue collection. However, when government
incurred budgetary deficits, they would resort into borrowing from both
foreign and local sources.
d. Expectations of the private sector businesses and individual consumers,
may be both a disadvantage and advantage to the implementation of
Fiscal policy. Fiscal policy may undermine the confidence of the private
sector and create expectation of future increase in taxes when taxes are

cut, thereby decreasing consumption and causing no change in national

income.
On the other hand, since consumers are becoming wiser, the government
may opt to implement Expansionary Fiscal Contraction or EFC just like
what happened in Ireland. As a result of contractionary measures such as
increasing taxes and lowering government spending, people are
conserving their resources and being wary about their consumption
decisions. If the government is perceived as serious and committed to
reducing deficit spending, it will create expectations that taxes will be
reduced in the future and risk premium on long-term interest rates will
decline. The expectation of future lower interest rates will boost
investments and the expectation of increase in future wealth or income
can further stimulate consumer spending. In short, due to this positive
outlook, economic activity will be potentiated. Consequently, aggregate
demand, employment, and output will intensify.