When a government spends heavily or cuts taxes during near-full employment, it risks "overheating" the economy. Excess demand pushes prices up, leading to high inflation.
Fiscal policy is a balancing act. While it is essential for correcting market failures and supporting growth, its misuse can lead to systemic instability. Achieving a "General Equilibrium" requires fiscal authorities to work in tandem with monetary policy to ensure that government actions don't inadvertently create the very imbalances they seek to avoid. Fiscal Policy and Macroeconomic Imbalances
To fund its debt, the government competes with the private sector for loans, driving up interest rates. This makes it harder for businesses to invest, slowing long-term productivity. When a government spends heavily or cuts taxes
To prevent these imbalances, modern economies use (like progressive income taxes and unemployment insurance). These tools naturally dampen volatility: While it is essential for correcting market failures
This inflow of foreign capital often appreciates the currency, making exports expensive and imports cheap, which leads to a Current Account Deficit . This phenomenon, where a budget deficit leads to a trade deficit, is known as the Twin Deficits Hypothesis . 3. Sovereign Debt and Financial Instability
In a boom, tax receipts rise and spending on benefits falls, naturally cooling the economy.