The government uses fiscal policy to influence economic patterns. Fiscal policy can be either expansionary of contractionary. Expansionary fiscal policy is employed to increase the aggregate demand whereas contractionary fiscal policy is used when there is need to decrease the aggregate demand. The three major fiscal policy tools include taxes, government spending and public debt. The principles of Fiscal Policy are founded on theories of John Keynes which hold that raising or decreasing revenue and expenditure influences inflationary and employment levels and the flow of money in an economy.
The fact that the U.S. Economy is below its optimal output and the projections of decrease in the world income and escalation of international oil prices necessitates employment of expansionary fiscal policy tools. The rationale is that occurrence of the two events are bound to result in low aggregate demand and thus low economic activity. United States as an oil importing country would suffer from upsurge in oil prices in a number of ways. High oil prices would generally cause rise in the level of inflation and reduction in economic growth. With regard to inflation, oil prices will have a direct impact on prices of goods and services that require petroleum products as input, for example transport and manufacturing sectors. The extra production costs are passed to the consumer (Blanchard & Galí, 2008). Since the world income is also projected to fall, high costs of goods and services resulting from the far reaching effects of high oil prices will stifle consumption of households and eventually low aggregate demand. In addition, hig oil prices will reduce the aggregate demand by depressing the supply of goods and services since they increase the cost of production (Blanchard & Galí, 2008).
In order to raise the aggregate demand and spur economic growth, the government will need to reduce rate of direct taxes such as corporation taxes and personal income taxes. This will in substance raise levels of incomes of individuals and firms which they will spend in consumption and investments, thus, raising the aggregate demand. The government should also consider increasing its expenditure, for example, in infrastructure projects and social security programs. Increased government expenditure would increase the aggregate demand through the multiplier effect. Furthermore, the government should correct deficiency in the aggregate demand by cutting its borrowing from the public in order to ensure that the purchasing power of the people is not reduced. In addition, the government should settle previous loans owed to the public to increase the disposable income of the people.
Keynes’s Criticisms of Classical Economists’ Economic Principle
Classical economists posit that market has inherent ability to regulate itself and attain equilibrium in the long run through the pricing mechanism. However, Keynes puts forward two major arguments against this principle.
Although growth of the economy follows a common trend that yields its potential income which is subject to its capacity, GDP differs from the common trend in the short run. Similarly, the short run equilibrium income of the economy differs from the potentiial income. The role of government is warranted when the equilibrium of the economy falls below the potential income. Keynes argues that the pricing mechanism might not restore the economy to its potential income equilibrium fast enough because of inflexibility of wages within the economy. This would create situations where the economies are stuck at low incomes and high levels of unemployment (Beveridge, Case, Fair, & Oster, 2009).
The idea that savings fuel economic growth ultimately depends on transfer of these savings back into the economy via investments. Nevertheless, when there is delay in this transfer, the aggregate demand or the GDP would fall. In order to ensure profitability, firms would cut production through layoffs or reduction in wages. This would reduce disposable income. This arguments justifies the need for government intervention in bringing the economy to its long run equilibrium in the short run (Beveridge, Case, Fair, & Oster, 2009).
In summary, the below optimal employment nature of the U.S. Economy and the expected fall in world income and rise in oil prices necessitate employment of expansionary fiscal policy tools, that is, decrease in rates of direct taxes, increase in government expenditure and reduction in government borrowing from the public. These fiscal measures should increase disposable income and consumption which are set to decrease in the face of low incomes and high commodity prices driven by escalation in oil prices. Keynes’ criticisms of classical economics on the role of government in economic markets are based on the argument that price mechanism alone cannot drive economy to its equilibrium in the short run.