What Is Fiscal Policy?: Economic Conditions Macroeconomic
What Is Fiscal Policy?: Economic Conditions Macroeconomic
What Is Fiscal Policy?: Economic Conditions Macroeconomic
Fiscal policy refers to the use of government spending and tax policies to
influence economic conditions, especially macroeconomic conditions. These
include aggregate demand for goods and services, employment, inflation, and
economic growth.
During a recession, the government may lower tax rates or increase spending to
encourage demand and spur economic activity. Conversely, to combat inflation, it
may raise rates or cut spending to cool down the economy.
Fiscal policy is often contrasted with monetary policy, which is enacted by central
bankers and not elected government officials.
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 British economist John
Maynard Keynes.
• Keynes argued that governments could stabilize the business cycle and
regulate economic output rather than let markets right themselves alone.
• An expansionary fiscal policy lowers tax rates or increases spending to
increase aggregate demand and fuel economic growth.
• A contractionary fiscal policy raises rates or cuts spending to prevent or
reduce inflation.
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.
Pessimism, fear, and uncertainty among consumers and businesses can lead to
economic recessions and depressions. What's more, excessive public sector
exuberance during good times can lead to an overheated economy and inflation.
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.
Fiscal Policy Example
During the Great Depression of the 1930s, U.S. unemployment rose to 25% and
millions stood in bread lines for food. The misery seemed endless. President Franklin D.
Roosevelt decided to put an expansionary fiscal policy to work. He launched his New
Deal soon after taking office. 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.2
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 causing fierce competition for
labor. In turn, this serves to raise wages and provide consumers with more
income to spend and invest. It's a virtuous cycle or positive feedback loop.
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.
The government does this by increasing taxes, reducing public spending, and
cutting public sector pay or jobs.
Where expansionary fiscal policy involves spending deficits, contractionary fiscal
policy is characterized by budget surpluses. This policy is rarely used, however,
as it is hugely unpopular politically.
The two major fiscal policy tools that the U.S. government uses to influence the nation's
economic activity are tax rates and government spending.
Eventually, economic expansion can get out of hand. Rising wages lead to
inflation and asset bubbles begin to form. 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.
The monetary policy tools that the Fed uses to increase or decrease liquidity (and affect
consumer spending and borrowing) include:4
In the legislative branch, the U.S. Congress authorizes taxes, passes laws, and
appropriations spending for any fiscal policy measures through its power of the
purse. This process involves participation, deliberation, and approval from both
the House of Representatives and the Senate.
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. 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.
When economic activity slows or deteriorates, the government may try to improve
it by reducing taxes or increasing its spending on various government programs.
When the economy is overly active and inflation threatens, it may increase taxes
or reduce spending. However, neither is palatable to politicians seeking to stay in
office. Thus, at such times, the government looks to the Fed to take monetary
policy action to reduce inflation.
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