Fiscal policy refers to any uses of the government budget to affect the economy. This includes government spending and levied taxes. Policy is said to be expansionary when spending increases or when taxes are lower. Conversely, policy is contractionary when spending decreases or taxes rise. Generally speaking, expansionary policy leads to higher budget deficits, and contractionary policy reduces deficits.

The accounting for government budgets is performed much like personal or household budgets, at least on the surface. A government runs a surplus when it spends more money than it taxes, and it runs a deficit when it spends more than it taxes.

Until the early 20th century, most economists and government advisers favored balanced budgets or budget surpluses. The Keynesian revolution and the rise of demand-driven macroeconomics made it politically feasible for governments to spend more than they brought in. Governments could borrow money and increase spending as part of a targeted fiscal policy.

Expansionary Policy

Governments can spend beyond their tax-based budgetary constraints by borrowing money from the private sector. The U.S. government issues Treasury Bonds to raise funds, for example. To meet its future obligations as a debtor, the government must eventually increase tax receipts, cut spending, borrow additional funds or print more dollars.

Not all economists agree about the net effect of expansionary fiscal policy on the budget in the long run. In the short run, either surpluses will shrink or deficits will grow.

Contractionary Policy

Contractionary policy simply refers to the opposite of expansionary policy. A $200 million tax cut is expansionary. A $200 million tax increase is contractionary. Under contractionary policies, deficits will shrink or surpluses will grow.

It is possible for a government to use both expansionary and contractionary policy tools at the same time. For example, the U.S. government might cut taxes and spending simultaneously. If the tax cuts are equal to $100 million in revenue and the spending cuts are only equal to $50 million, then the net effect is expansionary.