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.

  1. Monetary policy vs. Fiscal policy

    What is the difference between monetary policy and fiscal policy? Check out how government use these two policy tools to ... Read Answer >>
  2. What happens if the Federal Reserve lowers the reserve ratio?

    If the Federal Reserve decides to lower the reserve ratio through an expansionary monetary policy, commercial banks are required ... Read Answer >>
  3. Which countries run the largest budget deficits?

    Discover the countries with the largest budget deficits and what it means. Deficits are influenced by the economy and also ... Read Answer >>
  4. How can a change in fiscal policy have a multiplier effect on the economy?

    A change in fiscal policy has a multiplier effect on the economy because fiscal policy affects spending, consumption, and ... Read Answer >>
  5. How long has the U.S. run fiscal deficits?

    Read about the history of deficit spending in the United States, dating back to 1789, and learn how Alexander Hamilton addressed ... Read Answer >>
Related Articles
  1. Insights

    Trump Budget and CBO Budget Differ Widely

    The size of the difference between the administration’s assumption about economic growth and that of the CBO is unprecedented.
  2. Insights

    Twin Deficits: Twice the Fun for the U.S

    Learn more about what it means for U.S. to run both fiscal and current account deficits.
  3. Insights

    The U.S. National Spending And Debt

    Just like any average American household, government overspending can carry on for extended periods by rolling over debt and borrowing more and more money in what seems like a never-ending game ...
  4. Investing

    US Budget Deficit to Top $1 Trillion by 2020: CBO

    The budget office estimates the tax overhaul to cost $1.9 trillion over 10 years.
  5. Insights

    The National Debt Explained

    We know it's growing, but we don't know exactly how. An in-depth look why the U.S. Government's debt continues to balloon and what it all means for you.
  6. Personal Finance

    6 Things You Didn't Know About The U.S. Budget Deficit

    The country appears to be spiralling into more debt all the time, but is it really as bad as it looks?
  7. Insights

    4 Economic Indicators That Move Financial Stocks

    Find out about some of the most important macroeconomic indicators that investors in the financial services sector should watch out for when trading stock.
  8. Personal Finance

    Current Account Deficits: Government Investment or Irresponsibility?

    Deficit can be a sign of trouble for some countries, and of health for others. Find out what it means when more funds are exiting than entering a nation.
  9. Investing

    What's the Balance of Trade?

    The balance of trade is the difference between the value of all the goods and services a country exports and the goods and services it imports.
  1. Fiscal Policy

    The use of government spending and tax policies to influence ...
  2. Balanced Budget

    A balanced budget is a situation in financial planning or the ...
  3. Monetary Policy

    Monetary policy: Actions of a central bank or other committees ...
  4. Budget Surplus

    A budget surplus is a situation in which income exceeds expenditures. ...
  5. Open Market Operations - OMO

    Open market operations refer to the buying and selling of government ...
  6. Fiscal Deficit

    When a government's total yearly expenditure exceeds its yearly ...
Trading Center