What Is Fiscal Policy?

What Is Fiscal Policy?

Let me explain fiscal policy directly to you: it's how governments use spending and tax policies to shape economic conditions, focusing on big-picture elements like overall demand for goods and services, employment levels, inflation, and growth.

If we're in a recession, the government might cut taxes or ramp up spending to boost demand and get things moving again. On the flip side, to fight inflation, they could hike taxes or reduce spending to slow the economy down.

You'll often hear fiscal policy compared to monetary policy, which is run by central bankers rather than elected officials.

Understanding Fiscal Policy

In the U.S., fiscal policy draws heavily from British economist John Maynard Keynes, who lived from 1883 to 1946. He argued that recessions stem from shortfalls in consumer spending and business investments, which are parts of aggregate demand.

Keynes thought governments could step in by tweaking spending and taxes to cover those private sector gaps, stabilizing the cycle and managing output.

These ideas came out of the Great Depression, challenging the old view that economies fix themselves. They influenced the New Deal in the U.S., with huge investments in public works and welfare programs.

In Keynesian terms, aggregate demand—made up of consumer spending, business investments, government spending, and net exports—drives economic performance and growth.

Variable Private Sector Behavior

Keynesian economists point out that private sector parts of demand are too unpredictable, swayed by emotions like pessimism or fear, which can trigger recessions or depressions. Over-enthusiasm in good times can overheat things and cause inflation.

But governments can manage taxes and spending rationally to offset these swings, stabilizing the economy.

Corrective Government Fiscal Action

When private spending drops, the government can increase its own spending or cut taxes to boost demand directly. If the private sector is spending too wildly, the government can pull back on spending or raise taxes to cool it off.

This approach means running big deficits in downturns and surpluses in growth periods—these are expansionary and contractionary policies, respectively.

Fiscal Policy Example

Take the Great Depression in the 1930s, when U.S. unemployment topped 20% and seemed endless. President Franklin D. Roosevelt implemented expansionary policy with the New Deal, creating agencies, the WPA jobs program, and Social Security, which still exists. Combined with World War II spending, this pulled the country out of the slump.

Types of Fiscal Policies

Let's look at expansionary policy first: in a recession, the government might send out tax rebates to increase demand and growth. Lower taxes mean more money for people to spend or invest, leading to hiring, lower unemployment, higher wages, and a positive cycle.

They could also boost spending without tax hikes, like building highways to create jobs and demand. This often leads to deficit spending, where expenses outpace revenues, usually from tax cuts plus higher outlays.

For contractionary policy, to fight inflation, the government raises taxes, cuts spending, or reduces public jobs and pay, aiming for surpluses. It's unpopular politically, so monetary policy often handles cooling instead, with the Fed raising rates to curb money supply.

Downside of Expansionary Policy

Critics highlight growing deficits as a problem, saying they can drag on growth and force harsh austerity later. Some economists argue government spending crowds out private investment.

Expansionary policy is popular but hard to reverse politically—voters love low taxes and spending. This creates a bias toward ongoing deficits, rationalized as economic good, but it can lead to runaway inflation, asset bubbles, and eventual contractions.

Fiscal Policy vs. Monetary Policy

Fiscal policy is the government's job, using taxes and spending to speed up or slow down activity. Monetary policy belongs to the Federal Reserve, adjusting money supply for goals like full employment and stable prices.

The Fed's tools include buying/selling securities, lending to banks, changing rates, setting reserve requirements, and more.

Who Handles Fiscal Policy?

In the U.S., it's both executive and legislative: the President gets advice from the Treasury Secretary and Council of Economic Advisers, while Congress handles taxes, laws, and spending approvals through the House and Senate.

What Are the Main Tools of Fiscal Policy?

Governments use changes in taxation and spending levels. To stimulate, they lower taxes and increase spending, often borrowing. To cool, they raise taxes and decrease spending.

How Does Fiscal Policy Affect People?

Effects aren't equal: a tax cut might target the middle class, who pay more in tough times than the wealthy. Spending choices, like building a bridge, benefit construction workers, while a space program helps a niche group without broad job gains.

The Bottom Line

Fiscal policy aims for a healthy economy through tax and spending adjustments. In slowdowns, cut taxes or boost programs; in overdrive, raise taxes or cut back. Politicians avoid the latter, so the Fed often steps in with monetary tools to fight inflation.