What is Fiscal Policy?

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

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Fiscal Policy

The Roots of Fiscal Policy

Fiscal policy is largely based on the ideas of 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.

Key Takeaways

  • Fiscal policy refers to the use of government spending and tax policies to influence economic conditions.
  • Fiscal policy is largely based on ideas from John Maynard Keynes, who argued governments could stabilize the business cycle and regulate economic output.
  • During a recession, the government may employ expansionary fiscal policy by lowering tax rates to increase aggregate demand and fuel economic growth.
  • In the face of mounting inflation and other expansionary symptoms, a government may pursue contractionary fiscal policy.

Expansionary Policies

To illustrate how the government can use fiscal policy to affect the economy, consider an economy that's experiencing a 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 when people pay lower taxes, they have more money to spend or invest, which fuels higher demand. That demand leads firms to hire more, decreasing unemployment, and to compete more fiercely for labor. In turn, this serves to raise wages and provide consumers with more income to spend and invest. It's a virtuous cycle.

Rather than lowering taxes, the government may seek economic expansion through increases in spending. By building more highways, for example, it could increase employment, pushing up demand and growth.

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.

Fast Fact

Fiscal policy founder John Maynard Keynes argued nations could use spending/tax policies to stabilize the business cycle and regulate economic output.

The Downsides to Expansion

Mounting deficits are among the complaints lodged about expansionary fiscal policy, with critics complaining that a flood of government red ink can weigh on growth and eventually create the need for damaging austerity. Many economists simply dispute the effectiveness of expansionary fiscal policies, arguing that government spending too easily crowds out investment by the private sector.

Expansionary policy is also popular—to a dangerous degree, say some economists. Fiscal stimulus is politically difficult to reverse. Whether it has the desired macroeconomic effects or not, voters like low taxes and public spending. Eventually, economic expansion can get out of hand—rising wages lead to inflation and asset bubbles begin to form. Which can lead governments to reverse course and attempt to "contract" the economy.

Contractionary Policies

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. The government does this by reducing public spending and cutting public-sector pay or jobs.

Where expansion typically leads to deficits, contractionary fiscal policy is usually characterized by budget surpluses. This policy is rarely used, however, as the preferred tool for reining in unsustainable growth is monetary policy, as in adjusting the cost of borrowing.

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

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