In
the United States, fiscal policy is established through taxation to generate
revenues and the increase or decrease of government spending. The President and Congress are responsible
for determining the fiscal policy which ultimately affects the American
economy. Three main elements of the
economy are directly affected. These include aggregate demand, resource
allocation and distribution of income.
An
expansionary policy attempts to keep government spending above tax revenues and
is usually implemented during recessions to stimulate aggregate demand, as has
been the case over the past 12 years and in accordance with the economic theory
put forward by John Maynard Keynes. A
contractionary policy keeps government spending below tax revenues to pay down
the national debt and is implemented to stabilize prices during inflationary
economies, if Keynesian theory is accurate.
There
are opposing views by classical and neoclassical economists that argue the “crowding
out” effect of government spending. This viewpoint posits that when government
spending is in excess of revenues, the government must borrow funds from other
countries, issue government bonds and cause interest rates to rise. This results
in higher demand in the financial markets, lower demand for goods and services
and the government then appears to crowd out private sector spending.
These
two opposing economic theories are important to keep in mind as the White
House, Congress and both political parties attempt to arrive at a compromise to
begin paying off the national debt. The
two theories shed light on why it is so difficult for democrats and republicans
to strike a deal in the face of the impending fiscal cliff. Republicans appear to be favoring a
contractionary scenario where government spending is substantially reduced and
taxes remain low while democrats are favoring an expansionary scenario in which
government spending is increased and taxes are also increased. These
differences of opinion are difficult to overcome because they involve philosophical
beliefs and the correctness of each is not readily visible.
Article by: Joan Villazon, CFO
Consumer Debt Solutions, Inc.
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