The recent macroeconomic developments, such as the foreign and domestic factors causing the exchange rate depreciation along with the rising inflationary risks, has once again highlighted the importance of timely implementing active changes in fiscal policy in line with the monetary policy tightening. As there is a lively debate about the possible directions that fiscal policy could take: fiscal tightening, that would result reduced government spending and/or increased taxes or fiscal stimulus, that would result increased government spendings and/or reduced taxes. The aim of this research publication is to thoroughly analyze the possible effects of fiscal policy on the overall economy by presenting the international practices and main risks associated with their implication in short and long-run periods. Therefore, the publication only serves as an information pipeline for those interested in the issue.
Debates over the appropriate role and effectiveness of using fiscal policy as a tool for achieving macroeconomic stability have persisted for many years. On the one hand, it is important to assess macroeconomic effects of discretionary fiscal measures and their short and medium-term implications for economic soundness. On the other hand, analyzing the link between the effectiveness and composition of fiscal stimulus could be essential for understanding the effects of discretionary fiscal policy.
In the short term, changes in fiscal policy affects the overall economy by influencing the demand for goods and services by households, business and the government, which causes output to change relative to its potential level. For example, expansionary fiscal policy (decreasing taxes and/or increasing government spendings) boosts the demand and encourages businesses to produce and hire more. Increase in taxes and/or cuts in government spendings generally have the opposite effects. In the long run, changes in fiscal policy affect output level through three main channels: altering the government debt level, altering the incentives of households and businesses to work, save and invest and altering the government investment level, which itself can influence the productivity of capital and labor force. According to these, changes in fiscal policy should be designed by taking into consideration its short and long-term implications. Usually, changes in fiscal policy that have favorable effects in short-term have adverse economic effects in long-term. This phenomenon can be explained by the fact that increased demand for goods and services in short-term causes the output and income, and therefore tax revenues to increase in short-term. However, it does not offset the negative effect of direct increase in deficit. Consequently, such policies increase government borrowings, which reduce national savings and stocks of capital and eventually the level of output. Hence, under certain circumstances, fiscal policy change can have positive economic and budgetary effects in both short and long-term. This can happen, when short-term boost in the demand level positively influences the economy's long-term potential and therefore offsets the negative effect of the higher government borrowings.
According to the theoretical aspects discussed above, it is believed that countercyclical fiscal policy, that means encouraging the boost of the demand during economic downturns and reducing its level during economic booms, can play crucial role in macroeconomic stabilization. However, sometimes the countercyclical fiscal policy is not able to stimulate economy during downturns. For example, it might be inappropriate to use expansionary fiscal policy while the country is running considerably large current account deficit. In this case, due to reduced economic activity, implementing fiscal tightening in order to reduce inflation, current account deficit and/or the outflow of the capital might be inevitable. Furthermore, as opposed to standard Keynesian theory (according to which, fiscal tightening can negatively influence the output level by increasing unemployment and reducing the economic growth at least in short-term), it is believed that the tight fiscal policy can reduce the risk premium on interest rate, as a result of reduced government debt level, and therefore encourage increase in private investment and asset values. Hence, the crowding in effect of private investment can offset the reduction in the output level, which is mainly caused by reduced government spendings and increased taxes. Therefore, under discussed circumstances, fiscal consolidation can cause increase rather than reduction of the output level.
Pursuant to this discussion, analyzing the effectiveness of the fiscal policy as a tool for macroeconomic stabilization highly depends on the type of economy and the degree of monetary policy accommodation. Though fiscal consolidation can help improve the deficit in the balance of payment, implementing tight fiscal policy measures, while efforts taken by the central bank due to high inflationary risks and negative output gap are already tight, can be considered quite risky. In this case, one might consider implementing the neutral policy (moderately expansionary) and change its composition in a way that will be beneficiate in short and long-term.
Accordingly, while implementing fiscal policy, fiscal instrument can have considerable impact on economic and budgetary effects. For example, international practices of successful fiscal consolidation are usually ones that have tightened fiscal policy by reducing government spending rather public investment, nor by increasing taxes. (Read complete document in Georgian)