What Is Fiscal Policy & How Does It Affect the Economy?

Automatic stabilizers are fiscal mechanisms built into government budgets, such as taxes, unemployment insurance, and welfare programs. With government expenditures soaring, unemployment in the United States virtually disappeared. This marked another shift in fiscal policy, one that would occur during the post-war period. Keynes suggested that, to be most effective, fiscal stimulus should be financed by government borrowing rather than raising taxes or cutting government expenditures.

Recent examples of this include the Covid-19 stimulus packages and the Paycheck Protection Program. The central idea of fiscal policy is to find a level of public spending that stimulates economic demand without creating an undue tax burden. For example, stimulating a stagnant economy by increasing spending or lowering taxes, also known as expansionary fiscal policy, runs the risk of causing inflation to rise.

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A decision to spend money on building a new space shuttle, on the other hand, benefits only a small, specialized pool of experts and firms, which would not do much to increase aggregate employment levels. Federal Reserve Board and refers to actions taken to increase or decrease liquidity through the nation’s money supply. According to the Federal Reserve Board, these actions are intended to “promote maximum employment, stable prices, and moderate long-term interest rates—the economic goals the Congress has instructed the Federal Reserve to pursue.”

Contractionary policies are uncommon, though, because the preferred approach to reigning in rapid growth is to institute a monetary policy to increase the cost of borrowing. Fiscal policy refers to the governmental use of taxation and spending to influence the conditions of the economy. In the United States, Congress has set maximum employment and price stability as the primary macroeconomic objectives of the Federal Reserve. Otherwise, Congress determined that monetary policy should be free from the influence of politics. As a result, the Federal Reserve is an independent agency of the federal government.

What is Fiscal Policy?

Conversely, cutting spending or raising taxes might rein in an overheated economy, but risk stalling growth. It’s a dance of precision, requiring astute judgment and, often, a fair bit of foresight. The primary difference between fiscal policy and monetary policy is who’s calling the shots.

1. Successful monetary policy requires a delicate balance between spending and taxation.
2. For most people, an economic contraction brings some degree of financial hardship as unemployment increases.
3. 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.
4. Critics complain that a flood of government red ink can weigh on growth and eventually create the need for damaging austerity.

Implemented during President Franklin D. Roosevelt’s administration, the amount of deficit financing in this first round might not have been large enough to produce the desired effect. With expectations dulled by the Great Depression, businesses were too slow in seizing opportunities that fiscal stimulus measures presented. The two main policy types are expansionary and contractionary policies. Similarly, aggressive government involvement in certain sectors might deter private investment, undermining the very growth the policy aimed to achieve. By borrowing heavily, governments might drive up interest rates, making borrowing costlier for businesses. Through progressive taxation or targeted welfare programs, governments can redistribute wealth, ensuring a more equitable society.

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

Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity target costing and how to use it levels by increasing or decreasing tax levels and public spending. This influence, in turn, can curb inflation (generally considered to be healthy when between 2% and 3%), increase employment, and maintain a healthy value of money. Expansions typically occur as the economy is moving out of a recession.

Expansionary Policy and Tools

Alternately, rather than lowering taxes, the government may seek economic expansion by increasing spending (without corresponding tax increases). Building more highways, for example, could increase employment, pushing up demand and growth. During the Great Depression of the 1930s, U.S. unemployment rose to 25% and millions stood in bread lines for food.

The Great Recession of 2007 to 2009 was 18 months of substantial contraction spurred by the collapse of the housing market—fueled by low-interest rates, easy credit, and insufficient regulation of subprime mortgage lending. Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers.

This means that to help stabilize the economy, the government should run large budget deficits during economic downturns and run budget surpluses when the economy is growing. These are known as expansionary or contractionary fiscal policies, respectively. Expansionary policy, which is the more common of the two, is when the government responds to recession by lowering taxes and increasing government spending. Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group. In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class.

Typically, fiscal policy comes into play during a recession or a period of inflation, where conditions are escalating quickly enough to warrant government intervention. For this reason, fine-tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals. During a recession, out-of-work individuals can receive income assistance through unemployment insurance. On a larger economic scale, this program can help prevent disposable incomes from dropping to low levels that risk further slowing the economy. But as long as the government doesn’t reduce expenditures to compensate for its revenue loss, the economy’s automatic stabilizers can help temper declines in economic activity. Arguably, the first application of this new stabilizing technique in the United States was somewhat disappointing.

In a nutshell, Keynes believed that the government’s budget should be in deficit when the live full service economy is slowing and in surplus when economic growth is booming (usually accompanied by inflation). High inflation and the risk of widespread defaults when debt bubbles burst can badly damage the economy. This risk, in turn, leads governments (or their central banks) to reverse course and attempt to contract the economy.

President Franklin D. Roosevelt decided to put an expansionary fiscal policy to work. It created new government agencies, the WPA jobs program, and the Social Security program, which exists to this day. These spending efforts, combined with his continued expansionary policy spending during World War II, pulled the country out of the Depression. It aims to balance the budget, ensuring that government spending matches revenue. In periods of economic stability, a neutral approach avoids rocking the boat, maintaining the status quo and allowing the market forces to operate unhindered. By manipulating these levers, governments influence economic activity, direct and indirect, in an attempt to manage business cycles, control inflation, or even address unemployment.