Answer to Question #228924 in Microeconomics for Cebo

Question

Explain the two (2) main tools of fiscal policy

Answer 1

The main tools of fiscal policy are taxation and government spending.

Government Expenditure

Government expenditure comprises of current expenditures, capital expenditures and transfer payments. Generally, government expenditure is the expenditure of government revenue on consumption, transfer payments and investments. These three variables are vital in the stabilization of the economy. For example during recession the government may increase its expenditure with the aim of stimulating the economy. It contributes towards recovery of the economy from slump.

Government expenditure is used as a policy instrument that is aimed at reducing the severity of the rate of inflation in the economy and contributes towards lowering the prices of products and services. This can be done through reduction of government expenditure when prices are inflationary. Decreased government spending also help in the elimination of excess aggregate demand.

 

Taxation

Taxation is an effective tool in stabilizing the economy. Tax as a tool is made up of changes in government revenues or in rates of taxes which is aimed at either encouraging or instituting a restriction on private expenditures towards consumption and investment. Taxes determine the aggregate demand and the level of disposable income among the citizens. For example during recession and state of depression a tax policy is made that can encourage the level of private consumption among citizens and the level of investment. Tax policies determine the deflationary and inflationary gaps in the economy.