All About Fiscal Policy: What It Is, Why It Matters, and Examples

Whether it’s a struggling sector, a burgeoning industry, or a specific demographic, fiscal measures can be tailored to address precise challenges or opportunities. On the other, excessive understanding your paycheck withholdings debt can hamper economic activity, leading to long-term fiscal strain. Unemployment pay drops, tax revenue increases, and expenditures decrease. These three factors lay the general foundation for a government’s economic policy. Fiscal policy is often contrasted with monetary policy, which is enacted by central bankers and not elected government officials.

Fiscal policy is part of the financial infrastructure that helps keep the economy running like a well-oiled machine. While the fiscal policy you’re most familiar with is probably the taxes that you pay on every paycheck or purchase, fiscal policy at its core is any legislative move the government makes to drive the economy. Fiscal policy refers to taxing and spending policies of governments, often with a specific focus on budgeting and the effect of taxing and spending on the broader economy.

Expansionary economic policy is popular, making it politically hard to reverse. Even though expansionary policy usually increases the country’s budget deficit, voters like low taxes and public spending. Proving true the old saying that “all good things must end,” expansion can get out of control. The flow of cheap money and increased spending causes inflation to rise. High inflation and the risk of widespread loan defaults can badly damage the economy, often to the point of recession.

Fiscal Policy

By collecting tax revenues on individuals and businesses, via tax vehicles like capital gains and property taxes, among others, the federal government can steer financial assets to areas of the economy where they’re needed most. One of the biggest obstacles facing policymakers is deciding how much involvement the government should have in the economy. Indeed, there have been various degrees of interference by the government over the years.

1. Governments use a combination of fiscal and monetary policy to control the country’s economy.
2. Unemployment levels are up, consumer spending is down, and businesses are not making substantial profits.
3. To encourage expansion, the central bank—the Federal Reserve in the United States—lowers interest rates and adds money to the financial system by purchasing Treasury bonds in the open market.
4. Fiscal policy refers to the governmental use of taxation and spending to influence the conditions of the economy.
5. Automatic stabilizers are fiscal mechanisms built into government budgets, such as taxes, unemployment insurance, and welfare programs.

It’s not just about how much a government spends but where it allocates its resources. Infrastructure, healthcare, defense, education—the choices are vast, each with its ramifications on the economy. However, the challenge lies in ensuring these jobs are sustainable and not just short-term fixes. The issue of government paper money is, indeed, a new departure; but its purpose has been more distinctly monetary than fiscal. “It’s important to remember that this is where we are after several months of bounce back and an unprecedented amount of fiscal stimulus,” Bunker said. The only way out, Narayan says, is a fiscal push — by creating jobs and maintaining production.

Which of these is most important for your financial advisor to have?

In the executive branch, the office most responsible for fiscal policy is the President of the United States along with the Cabinet-level Secretary of the Treasury and a presidentially appointed Council of Economic Advisers. Congress, using its constitutionally granted “power of the purse,” authorizes taxes and passes laws appropriating funding for fiscal policy measures. In Congress, this process requires participation, debate, and approval from both the House of Representatives and the Senate. In Keynesian economics, aggregate demand or spending is what drives the performance and growth of the economy.

Therefore, the preferred tool for reining in unsustainable growth is usually a contractionary monetary policy. Monetary policy involves the Federal Reserve raising interest rates and restraining the supply of money and credit in order to rein in inflation. The purpose of fiscal policy is to implement artificial measures to prevent an economic collapse and to promote healthy and steady economic growth. With fiscal policy, the U.S. government, via the executive and legislative bodies, shapes large economic decisions. The federal government relies on taxes and government spending as its primary tools.

Price Stability

For most people, an economic contraction brings some degree of financial hardship as unemployment increases. The longest and most painful period of contraction in modern American history was the Great Depression, from what are noncash expenses meaning and types 1929 to 1933. The recession of the early 1990s also lasted eight months, from July 1990 through March 1991. The recession of the early 1980s lasted 16 months, from July 1981 through November 1982.

Before the Great Depression, which lasted from 1929 until America’s entry into World War II, the government’s approach to the economy was largely laissez-faire. Following World War II, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation, and the cost of money. By using a mix of monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments can control economic activity.

What is Fiscal Policy?

However, Keynesians believe that government taxation and spending can be managed rationally and used to counteract the excesses and deficiencies of private sector consumption and investment spending in order to stabilize the economy. Contractionary policies are uncommon because the preferred approach to reigning in rapid growth and inflation is to institute a monetary policy to increase the cost of borrowing. A neutral fiscal policy is the Goldilocks of fiscal strategies—not too expansionary, not too contractionary, but just right. During this the government may reduce spending on public projects or even reduce public-sector wages or the size of the workforce. One primary aim of fiscal policy is to foster sustainable economic growth while ensuring stability. The tax overhaul is forecast to raise the federal deficit by hundreds of billions of dollars—and perhaps as much as $2 trillion—over the next 10 years.

Fiscal policy plays a very important role in managing a country’s economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase in tax rates and cuts in government spending set to occur in January 2013, would send the U.S. economy back into recession. The U.S. Congress avoided this problem by passing the American Taxpayer Relief Act of 2012 on Jan. 1, 2013. Many politicians have found it unfavorable to raise taxes and cut government spending during an economic boom, even when the economy shows signs of overheating. In addition, so-called “automatic stabilizers” in the economy have inhibited the government from taking a more discretionary approach to fiscal policy. If the government increases taxation (to generate more revenue) or reduces its spending, both can slow economic growth, possibly leading to a contraction or recession.

In the face of mounting inflation and other expansionary symptoms, a government can pursue contractionary fiscal policy, perhaps even to the extent of inducing a brief recession in order to restore balance to the economic cycle. When private sector spending decreases, the government can spend more or tax less in order to directly increase aggregate demand. When the private sector is overly optimistic and spends too much, too quickly on consumption and new investment projects, the government can spend less or tax more in order to decrease aggregate demand. Keynes believed that governments could stabilize the business cycle and regulate economic output by adjusting spending and tax policies to make up for the shortfalls of the private sector.