Question

If economic advisers fear that the economy is growing too rapidly what fiscal policies should they recommend?

Answer 1

Fiscal policy defines how, by taxes, the central government earns money and how it spends money. A government will cut tax rates while rising its own spending in order to help the economy; it will raise taxes and slash spending in order to cool down an overheating economy. There is a lot of discussion as to whether monetary or fiscal policy is the best economic tool, and every policy has pros and cons to consider. If the economy grows too rapidly, by raising interest rates and removing money from circulation, the central bank can implement a tight monetary policy.

On the other hand, in hopes of reducing economic growth for various reasons, contractionary fiscal policy entails increasing tax rates and decreasing government spending. Thus, if inflation caused by increased cash supply and demand comes out of hand, the government may deem it necessary to halt or deter economic growth.

Contractionary fiscal policy in this way reduces the amount of money in circulation and therefore-the amount available to consumers to spend. If an economy is booming and growing too rapidly (as can be caused by expansionary fiscal policy)-which, according to normal rates, should not exceed 3 percent per year-it may need to be remedied by contractionary fiscal policy. So, when economic growth is unsustainable and causes inflation, high investment prices, unemployment below healthy levels, and recession, contractionary fiscal policy is often employed.

And, this unpopularity also leads to an increase in the budget deficit through the issuance of more treasury bonds by the government–which, considering the debt imbalance of GDP, would trigger interest rates to rise as treasury bond holders are nervous not to be repaid by the indebted state. Today, higher interest rates are actually perpetuating many of the problems.