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Principles of Macroeconomics

Purposes, Tools, and Limitations of Fiscal Policy

The government employs fiscal policy through spending and taxation whenever there is a need to influence the economy. The policy can be tight or contractionary when it results in higher revenues than spending and expansionary when it results in higher spending than revenues. The purpose of fiscal policy is to enable the government to influence on a nation’s economy by adjusting its spending and/or taxation rates. The main objectives of such adjustment include stimulating economic growth during recession periods, keeping inflation rates low, and stabilizing economic growth by avoiding cyclic periods of boom and busts.

In order to achieve the desired outcome, the government employs specific fiscal policy tools, which are spending and taxes. On the one hand, government spending serves to increase the amount of money in circulation and thereby enhancing people’s purchasing power, hence economic growth. On the other hand, taxes tend to influence, either positively or negatively, the cost of living, which, in turn, influences economic performance. Often, the major target of fiscal policy is to influence aggregate demand for goods and services. It raises aggregate demand through increased government purchases while holding taxation rates constant or by cutting taxes that, consequently, raises the amount of household disposable income. Alternatively, if the target is to correct existing deficit, the government issues bonds, raises interest rates and extinguishes private investment.

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Despite its assumed pragmatism in creating balance within an economy, fiscal policies have inherent limitations. One of the major limitations of fiscal policy includes policy lag, the difference in time between when an action is needed and when the fiscal measure delivers the impact. The second relates to the difficulty in forecasting economic events, which jeopardizes effective planning given the lack of knowledge on the extent of budget balance or the amount of expenditure necessary. Another limitation relates to difficulties in framing the correct size and nature of the policy or the correct timing for its application. Other factors include inherent inadequacy in measures, self-offsetting effects such as discouraging investment, adverse effects on debt management, failure to offer solution to existential unemployment, etc.

The Cyclically Adjusted Budget

The cyclically adjusted budget reveals the status of the U.S. fiscal policy by first removing the endogenous components of spending and revenues and then determining the possible size of the federal budget surplus or deficit if the economy was operating at full employment. The cyclically adjusted budget attempts to determine the underlying budget balance, which is the fiscal position of the prevailing temporary factors expected to disappear over time. To achieve this, the cyclically-adjusted budget deconstructs the existing deficit into a fiscal policy component and a cyclical component, assess the magnitude of fiscal impulse and examines the policy’s sustainability. 

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The U.S. Public Debt

According to Treasury Direct (2016), the U.S. national debt estimates at $19.5 trillion, at the end of the federal government’s 2017 fiscal year. In fact, $11.7 trillion out of the total amount belong to the ‘held by public-other’ category, $2.46 trillion are held by the Federal Reserve System, and Federal Government Accounts has a $5.4 trillion debt. The consequences of such debts are that it reduces the amount of money available for future spending since it accumulates interest and the payment thereof affects the country’s economic growth. Furthermore, the fact that part of the debt is owed to the country’s Social Security Trust Fund implies that future increase in taxes, given that is the only means of repaying it, is imminent.

A Long-Run Fiscal Imbalance in the Social Security System

Regarding the existence of a long-run fiscal imbalance in the Social Security System, the problem is attributable to the fact that the U.S. population is aging at a rate never seen before. As such, the derailment of this system is primarily the effects of changing demographics. People who participated in the mid-twentieth century Baby Boom are currently entering retirement age, and a rising life expectancy implies that more people will need to receive the Social Security benefits for a longer period. Furthermore, reduced birth rate implies that increasingly fewer workers are contributing to the payment of each worker’s benefits. Taken together, these have the implication that the system will need to pay out more annually under currently legislated benefits than its total receipt from tax revenues and interests (National Research Council, 2012).

Types of Unemployment and Inflation and Their Economic Impacts

There are three main types of unemployment, namely, structural, frictional, and cyclical. Structural unemployment occurs when a labor market has fewer jobs than demanded. Structural unemployment has been on the rise for the past several decades due to the withering of jobs in such industries as mining and manufacturing, compelling individual lacking alternative contemporary skills to perhaps, permanent unemployment. Frictional unemployment occurs when a mismatch, related to skills, location, work time, etc. between workers and available jobs exists. As such, it is always present to some degree in any given economy. Noteworthy, such case is largely the result of voluntary decisions individuals make based on their valuations of amount of work and accompanying rewards.

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Cyclical unemployment, on the other hand, exists when the economy has the limited aggregate demand to provide jobs for those seeking them. At times, an economy may be such that demand for goods and services decline, to which a feasible countermeasure is less production, but which translates to the need for increasingly fewer workers. The result is the existence of a greater number of unemployed workers compared to the number of vacancies available. The condition transits to either demand deficient, general or Keynesian unemployment when the decline in aggregate demand persists, and unemployment becomes long-term.