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What is 'Fiscal Policy'

Fiscal policy refers to the use of government spending and tax policies to influence macroeconomic conditions, including aggregate demand, employment, inflation and economic growth.

BREAKING DOWN 'Fiscal Policy'

Fiscal policy is largely based on the ideas of the British economist John Maynard Keynes (1883-1946), who argued that governments could stabilize the business cycle and regulate economic output by adjusting spending and tax policies. His theories were developed in response to the Great Depression, which defied classical economics' assumptions that economic swings were self-correcting. Keynes' ideas were highly influential and led to the New Deal in the U.S., which involved massive spending on public works projects and social welfare programs.

To illustrate how the government could try to use fiscal policy to affect the economy, consider an economy that's experiencing recession. The government might lower tax rates to increase aggregate demand and fuel economic growth; this is known as expansionary fiscal policy. The logic behind this approach is that if people are paying lower taxes, they have more money to spend or invest, which fuels higher demand. That demand in turn leads firms to hire more – decreasing unemployment – and compete for labor, raising wages and providing consumers with more income to spend and invest: a virtuous cycle.

Rather than lowering taxes, the government might decide to increase spending. By building more highways, for example, it could increase employment, pushing up demand and growth as described above. Expansionary fiscal policy is usually characterized by deficit spending, when government expenditures exceed receipts from taxes and other sources. In practice, deficit spending tends to result from a combination of tax cuts and higher spending.

Economic expansion can get out of hand, however, as rising wages lead to inflation and asset bubbles begin to form. In this case a government might pursue contractionary fiscal policy – similar in practice to austerity – perhaps even forcing a brief recession in order to restore balance to the economic cycle. The government can do this by reducing public spending and cutting public sector pay or jobs. Contractionary fiscal policy is usually characterized by budget surpluses. It is rarely used, however, as the preferred tool for reining in unsustainable growth is monetary policy.

When fiscal policy is neither expansionary nor contractionary, it is neutral.

Aside from spending and tax policy, governments can employ seigniorage – the profits derived from printing of money – and sales of assets to effect changes in fiscal policy.

Many economists dispute the effectiveness of expansionary fiscal policies, arguing that government spending crowds out investment by the private sector. Fiscal stimulus, meanwhile, is politically difficult to reverse; whether it has the desired macroeconomic effects or not, voters like low taxes and public spending. The mounting deficits that result can weigh on growth and create the need for austerity. 

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