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Expansionary and Contractionary Fiscal Policy

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Published: Mon, 22 May 2017

Fiscal policy basically refers to the government change in it spending or purchases and taxes in order to affect the household and firms spending, to solve unemployment rate and to maintain the price levels of goods and services. Fiscal policy can be divided into three categories which are policies concerning government purchases of goods and services, policies concerning taxes and policies concerning transfer payment. (Karl E. Case, Ray C. Fair, Sharon M. Oster, 2009) Discretionary fiscal policy carried a meaning that the deliberate use of changes in government’s spending and taxes. (Tucker, 2010) Due to the decrease and increase in spending and taxes will change in respond to the state of economy, thus policy makers will make use of this discretionary fiscal policy occasionally. Automatic stabilizers also can be called as non-discretionary fiscal policy. It is a “built-in” mechanism where federal spending and taxes change automatically with the state of the economy in order to stabilize the GDP. For example, during the recession, government spending automatically increases by paying the unemployment benefit to the unemployment workers over this period.

There are two types of fiscal policy that government applies to combat with the recession and inflation which are expansionary and contractionary fiscal policy.

Government used expansionary policy to overcome a recession. In the expansionary policy, government will increase their spending and decrease the tax charge on the households and firms. Over the period of recession, people will buy less on goods and services or they will just concern on buying the fundamental goods, thus it lead to a decrease in the demand of goods and services. At the equilibrium, someone spending will always become the others person income. Hence, a decrease in spending refers to a decrease in income. In order to boost the economy, government increase their spending through some activities, such as spending on building the highway, education sponsor, health care programs and so on. Furthermore, government also decreases the tax that increases the people disposable income and indirectly encourages people to spend more.

Contractionary fiscal policy serves by government to fight against the inflation. The high demand of goods and services will lead to inflation which called demand-pull inflation. In order to combat with this high price level, government decreases their spending and increase the tax rates. A decrease in government spending will in turn affect the aggregate demand curve decrease and shift downward. With the real GDP unchanged, the overall price levels of goods and services reduce due to the aggregate demand curve shift downward. Besides, government also decreases the demand by increase the tax rates so that people will have lesser disposable income to spend on goods and services.

When government applied fiscal policy at work, there are three types of multiplier effects which included government spending multiplier, tax multiplier and balanced-budget multiplier. The government spending multiplier refers to the ratio of change in the real GDP to a change in a government spending while tax multiplier means the ratio of change in the level of output to a change in taxes. (Karl E. Case, Ray C. Fair, Sharon M. Oster, 2009) The balanced-budget multiplier shows the equal change in government spending and taxes which simultaneously changes the aggregate demand by the amount of the change in government spending. (Tucker, 2010) .

Implementation of Fiscal Policy

In year 1992 to 1996, Japan implemented the fiscal policy to find out the country’s economic problem. The government first applied 10 trillion yens package that equal to 2.2% of GDP during that time and five other packages till year 1996. The total of the packages were worth 59.6 trillion yens to arouse the country’s economy. The packages were counted in the budget deficit. There was budget surplus, 2% of GDP during year 1990 but a budget deficit of almost 5% during year 1995. After a long recession, the economy of Japan started to recovery in year 1996. In the end of year 1996, Japanese government replaced the policy from expansionary to contractionary which to indicate the increasing of debt problem.

In year 1997, Japanese government was urged by the Ministry of Finance (MoF) to carry out a combination of fiscal policy to overcome the Japan’s debt problem that concern about domestic and international. Japan needed to lowering and trimming the government deficits and debts. In year 1997, Prime Minister Hashimoto used the Fiscal Structural Reform Act to reform the budget. The act was hoped to be last long as the reform period during year 1998, 1999 and 2000. The act was aimed to balance the budget of year 2000 and hope the economy of Japan can recover after the deficit at year 1996. The economy was getting recovered as a result of the GDP growth rate in the following years of 1996 and Japanese government had implemented the budget constraint to limit the government’s spending. The starting of year 1997 was applied by the rigid fiscal discipline then fiscal policy was being turn down unexpectedly.

For year 1999 to 2000, the economy of Japan was get into a new recession that Japanese government unwilling to face and the Prime Minister Hashimoto made a decision to implement a fiscal stimulus package and three stimulus packages that indicate 9.8% of GDP was being authorized between October and December of the year. The packages were against the Fiscal Structural Act and approval was not allowed by the Ministry of Finance (MoF) of Japan. Election was made during July 1998 and Obuchi replaced Hashimoto as the new Prime Minister but economy keep on worsen. Obuchi enacted a funding plan that worth 16 trillion yens as 3.25% of GDP to support the country’s bank that facing worse situation but not through fiscal expansion. Japanese economy facing the worst situation as the end of World War II which Obuchi hoped to gain back the confidence of Japanese economy by implemented a stimulus package plan that worth 10 trillion yens as sum into the previous Hashimoto’s April stimulus package. The economy rebound and the real GDP increased as predicted and Fiscal Structural Act was suspended at the same year.

During September 11st of year 2000, the IT crisis bubble had end the recovery period of Japanese economy although the fiscal packages were being implemented. Two economic policy packages were being implemented in year 2002 as to overcome the slowdown of the economy and poor performance of IT sector. The first policy package was a reform program that focusing on job creation and job security then the second policy package was focusing on stimulated the structural reform. These packages were hoped to recover the confidence as well as had a better incentives of private sector and no fiscal expansion was implemented during that period of time.

The GDP of Japanese economy had growth since 2002 and there was a steady growth in following year 2003 to 2007 and these years also known as the recovery period of the economy. Japanese government targeted a growth rate of 2.2% through year 2015 during year 2006. On 26th of January 2007, the Minister of Finance gave a speech that emphasized on the fiscal consolidation which a policy that help to decrease spending and expenditure perhaps the lowering of government debt by using contractionary approach.

In conclusion, Japanese government had hesitation while implementing the expansionary fiscal policy at year 1990 to year 2007 and never carried out the policy with full confidence and range. Japanese government implemented expansionary fiscal policy when they noticed the their country economy was in an urgent and stopped to continue implemented when the economy was back to normal during year 1992 to year 1996 and year 1998 to year 2000.This showed that Japanese government only used fiscal policy as a transition for the economy to back to normal and not directly affected the private financial assets which was Japanese yen. Once the country economy facing downturn, Japanese government only will react rather than consistently applied the fiscal policy.

The effectiveness of Fiscal Policy in Japan

In year 1992 to 1996, Japan met some confrontation toward economic decline by applying expansionary fiscal policy. The decline in the annual Real GDP from year 1990 to1993 had aroused the financial crisis in Japan. The implementation of fiscal packages cause the growth rate never turns negatively. The real GDP growth rate in 1993 was fell from 0.8% to 0.2%, it was then rose to 1.1% in 1994, 2% and also 2.7% from 1995 to 1996. In 1990 to 1995, the debt in Japan was grown and this makes Japanese to focus more on the debt control and fiscal restraint and in 1996, the expansionary fiscal policy was discarded due to worry of the growing debt problem shared by local country and international policy makers. While in between 1992 and 1996, Japanese policy makers were doubtful about the implementation of fiscal policy due to the expansionary of the problem of the growing deficit in Japan. There have six stimulus fiscal packages applied in between 1991 to 1996, these made the economy of Japan went from a recession (1992) to a vigorous recovery (1996), which the real GDP rate reached 2.7%.

While in between year 1997 to 1998, Japanese policy maker were made things Abridging worse. At the year ended of 1996, Japanese policy makers were changed the expansionary fiscal policy to contractionary fiscal policy due to the increasing of debt in Japan. The implementation of contractionary fiscal policy had made the situation become exacerbate compare to previous approach, which the real GDP growth rate for 1997 and 1998 fell from 1.6% to -2%. In 1998, the decline of the consumption spending accompany with the deep Asian crisis were brought Japan into a negative growth economy, procyclical fiscal policy and low investor confidence. In full words, the implementation of contractionary approach which supported by the Fiscal Structural Reform Act were totally failed.

In Late 1998 to 2000, Japanese policy makers returned to expansionary fiscal policy disjointed framework. Again, at the year ended of 1998, a series of stimulus packages were implemented to reviving the economy. These stimulus packages cause the real GDP growth rate first decline to -0.1% in 1999 and then gradually picked up to 2.9% in 2000, the fiscal policy had kicked once again. At that time, the budget deficit was ballooning, fiscal stimulus packages reported that the GDP in 1998 and 1996 as 9.8% and 6.2% respectively. In the beginning, the economy was successfully picked up under the expansionary approach, but, unfortunately, in 11th September 2001, the happened of IT Bubble crisis had made a negative effect on the GDP growth rate which wall fell to below 0.2%. This indicate that the insufficient of fiscal expansion policy. This conclude once again, the overturn of the fiscal policy accompany with a global recession had turned the economy of Japan worse to even worst.

Japan was struggle for fiscal consolidation in year 2001 to 2007. In 2001, there was once again changed expansionary fiscal policy to contractionary fiscal policy. The main purpose for this changing is to limit the amount of government bond issues and also to achieve a surplus. After changing to contractionary approach, the annual real GDP growth rate in Japan was 0.3% in 2002, 2.7%, 1.9% in 2004 and 2005 and 2.39% in 2007. The real GDP growth rate in Japan still considered inferior compared to the world GDP growth rate. At the same moment, the unemployment rate in Japan was increase steadily over the time.

To conclude the overall performance in implementation and sustainability of fiscal policy, Japan was found that they was failed in boost up their economy condition and they even turn it worse due to the intermittent and incongruous in implementing the fiscal policy. This can be proven by The Economist claimed (April 2, 2009, article), “Japan is in danger of suffering not one but two lost decades”.

Conclusion and comment

Japanese government debt is in critical state. The tax revenue is unable to increase when the debt to GDP ratio increases. The government has continued to have budget deficit that last for two decades. Although there were sometimes when the budget deficit decreased during economy recovery period, Japan’s debt to GDP ratio still increased rapidly throughout the years. It is known that the Japanese government sector has its own significant financial assets, which some of it are invested in its own government bonds. This may help government to raise money and reduce its debt. However, it is not really practical and effective as Japan’s debt to GDP ratio has been always the highest compared to other countries. Hence, Japan needs to increase its tax rate with large magnitude in order to stabilize its debt to GDP ratio. Tax revenue can be used to redeem some of its debt. In other way, Japan can default on some of its debt obligation to reduce its debt.

On the other hand, Japan’s active fiscal policy is supported by inactive monetary policy for the last 30 years. An active policy is not guarded by the level of the government while the passive policy reacts providentially to the government debt. Japan’s fiscal policy is found to be in overall stable stage in the early year from 1885-2004. However, the surplus is substantially positive to the increase of debt in Japan. If Japan continues to practice this method, the government would be forced to reduce its debt through inflation. Inflation can reduce government debt and show how to treat financial repression as a restructuring mechanism. This is because inflation can erode the real value of the debt held by creditors and debt ratio. With foreign creditors owning a significant share of Japan federal debt, they will share the burden of any higher Japan inflation along with the domestic creditors.

However, it is unlikely as Japan now is already in deflationary state. Therefore, Japan’s fiscal policy is found to be impractical in solving its debt to GDP ratio problem. Unless Japan is able to back to the policy regime that is under gold standard or effective balanced budget legislation, if not Japan fiscal policy will be unsustainable.

Lastly, parts of Japan’s accumulated debt are due to unexpected slowdown in its economy growth that leads to higher debt to GDP ratio as they may have taken on more debt to support that growth. Hence, Japan should boost up it GDP so that it can grow fast enough to reduce the debt ratio. Government also can cut the spending to reduce their debt burden. However, the trick to cut the spending successfully is no to deter the growth.


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