Scope for Using Fiscal Policy to Stabilize the Economy with High Public Debt

Economics Assignment
Students Name
Macroeconomics
Course Instructor
Date

Student last name 1
Q1. Explain the scope for using fiscal policy to stabilize the economy when public debt is
high.
Notably, fiscal policy has been instrumental in the management of macroeconomic
indicators. Usually, public debt occurs when public expenditure exceeds public revenue hence
causing a deficit. In an effort to curb over expenditure in the public sector, most governments
implemented contractionary and expansionary fiscal policies to stabilize macroeconomic
conditions in the economy respectively. In the event that public expenditure depends on foreign
borrowing might lead to high public debts. In addition to reliance on foreign funding for public
expenses, overreliance on private sector loans to finance public sector expenditure might lead to
high levels of public debts.
In the event that the government does not invest more than it spends might occasion a rise
in the public debt values hence the implementation of fiscal policy1 Notably, reduced
government expenditure is more effective in curbing public debt as compared to taxation
increase. Primarily, the increase in tax rates and cutting down of public expenditure has been key
in curbing the rising public debt levels in most countries2. Fiscal policy, contractionary or
expansionary has been used to stabilize macroeconomic conditions and also curb public debt
However, reducing public expenditure is more effective in curbing the rise in public debt.
Should you engage in a fiscal stimulus or austerity? Why? What would be an optimal
approach in your opinion? Pick one country of your choice and use it as an example
In the event of high public expenditure debts, austerity seems a prudent choice. This is
because austerity provides ways to reduce the accumulation of public expenditure3. Specifically,
increased taxation regimes, reduced government expenditure are some of the most commonly
used policies to curb public over expenditure. A case in point is the United KingdomIn addition
to the UK,Greece and Spain have also cut public expenditure. Particularly, in the year 2008, the
1 World Bank Group,”Fiscal Policy for stabilization and adjustment”
2 Mohanty,”Fiscal policy,public debt and monetary policy in EMEs”
3 Corporate Finance Institute,”Exchange rate Risk”

Student last name 2
United Kingdom was in recession and implemented these policies to reduce the excessive public
expenditure at the time. Specifically, the United Kingdom government did raise the taxes to curb
the budgetary deficit at the time. In addition to increased taxation, the United Kingdom
government implemented sector budgets to curb public expenditure .
The reason for choosing austerity is because it is more effective and direct to curbing the
problem of rising public debt. This is because budget cuts for different sectors of the economy
will effectively reduce the rate of public expenditure. Whereas tax increase is effective in the
long run in reducing public debt by raising revenue, the effects are not felt immediately and it
might take time to raise the revenue required to offset the existing public debt. Reducing public
expenditure is the right course solution because it is the direct cause of rising debt. In the United
Kingdom in 2008 and Spain cases in 2011, budget cuts to public sectors of the economy yielded
results without the imposition of higher taxes.
Q2. Explain how the ECB, by setting the interest rate, has a knock-on effect on (i) liquidity
and market interest rates in the euro area;
Essentially, interest rates directly affect liquidity and market interest rates in the long and
short run. The European Central Bank has been tasked with the mandate of stabilizing monetary
and fiscal policies of the European member states thus the universal application of the interest
rate targets by its member states. Basically, liquidity implies the degree to which assets or
securities can be purchased quickly without affecting asset prices. Majorly, market liquidity
denotes selling and buying of assets at stable prices. In the event that the ECB reduces the
interest rate for its member states, the rate of borrowing in the Eurozone will increase (demand
increase). For market interest rates, an increase in the interest rates in the Eurozone will cause a
decrease in the economic activity in Eurozone economies4 .This is due to increased borrowing
costs. However, a decrease in the interest rates will cause an increase in borrowing and
investment due to low repayment rates.
4 Brauning,”The liquidity effect of the federal reserve”