Answer to Question #277480 in Microeconomics for Shiks

Question

Explain how fiscal policy can be used to encourage economic growth.(4)

Answer 1

Fiscal policy is a government's decisions regarding spending and taxing. If a government wants to stimulate growth in the economy, it will increase spending for goods and services. This will increase demand for goods and services. Since demand goes up, production must go up. If production goes up, companies may need to hire more people. People that were once unemployed may now have jobs and money to spend on goods and services.

This will further increase the demand and require more production and, hopefully, the cycle of growth will continue. Barry may even get more business as people have more money to spend on products at his store. Consequently, government spending tends to speed up economic growth.

If the government thinks the economy is overheating - or growing too fast - the government may decrease spending. A decrease in government spending will decrease overall demand in the economy.

Businesses will slow production, which means profits will decline, resulting in less hiring and business investments. A cut in government spending may hurt Barry's business, because there will be less money in people's pockets to spend at his store, possibly from being laid off. If Barry provides goods or services to the government, he may take a double-hit.

The other side of fiscal policy is taxes. Decreasing taxes tends to stimulate economic growth. If taxes go down, Barry will have more money in his pocket. He'll either spend it or save it. If he spends it, he increases demand and businesses have to produce more. This means they may have to hire more people. These people will then have more money to save or spend - maybe at Barry's store. On the other hand, if Barry saves the money, he'll put it in his bank. The bank will loan the money he deposited, and borrowers will spend it.

Some economists are concerned that government spending and reduction in taxes will create a crowding out effect. If the government doesn't have enough revenue to support spending, it will have to borrow money. According to some economists, government borrowing tends to increase interest rates. And, increased interest rates discourage individuals and businesses, like Barry, from borrowing money for spending and investment. According to these economists, government spending may crowd out private investment.