Business, Politics, & Society

What Is Fiscal Policy? Types of Fiscal Policy and How Fiscal Policy Works

Written by MasterClass

Aug 31, 2019 • 5 min read

How much money should the government collect in taxes, and how should the government spend the money that it raises or borrows, as the case may be? These are the central questions of fiscal policy. When combined with monetary policy, fiscal policy makes up economic policy, which is how governments attempt to influence and regulate the economy. While all governments rely on fiscal policy to promote economic growth, politicians and economists are constantly debating how and when government intervention is best.

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What Is Fiscal Policy?

Put simply, fiscal policy is the use of spending and taxation to influence the economy. It determines not just how much the government taxes and spends, but who pays those taxes and where that government spending is directed.

At a macroeconomic level, fiscal policy can have a major impact on:

  • Aggregate demand
  • Savings and investment
  • Income distribution
  • The distribution of resources and money supply
  • The business cycle
  • Tax rates

What Is the Purpose of Fiscal Policy?

Generally speaking, the objective of fiscal policy is to promote sustainable economic growth. There are a few key metrics that economists look at when gauging the overall health of an economy. These include:

  1. Price stability. Price stability is measured by the rate of inflation, which is ideally kept between 2–3%.
  2. Economic growth. Measured by the rate of Gross Domestic Product (GDP) growth, also ideally between 2–3%.
  3. Employment rate. Measured by the unemployment rate, which most economists try to keep between 4–5%.

How Was Fiscal Policy Developed?

Fiscal policy comes out of the Great Depression and is based on the economic theories of John Maynard Keynes. The collapse of the global economy in the 1930s presented a severe challenge to traditional economic theories, which tended to regard markets as self-regulating machines. Keynes argued persuasively that in times of reduced demand (in other words, during recessions), governments could stimulate demand. According to Keynes, fiscal policy was one of the major tools that governments could use to combat inflation and promote employment (the other being monetary policy).

According to the standard Keynesian view, governments can stimulate demand by increasing spending and lowering taxes. Conversely, they can slow economic growth (and reduce inflation) by raising taxes and reducing spending.

Who Determines Fiscal Policy?

In the United States, fiscal policy is determined by the legislative and executive branches. (By contrast, monetary policy is generally set by central banks.) Governments, like the U.S. Congress, make fiscal policy every time they release a budget or approve new spending or tax levels.

In the U.S., the president submits a budget to Congress, which outlines the administration’s spending priorities and expected tax revenue. Congress then develops its own spending resolutions and appropriations bills, which the president must sign before they become law.

What Are the 3 Types of Fiscal Policy?

There are three different types of fiscal policy, each depends on the state of the economy and the government’s policy objectives.

  1. Governments may support an expansionary fiscal policy in order to promote growth during an economic downturn. An expansionary fiscal policy usually involves greater spending in excess of tax revenue than during normal periods, especially on measures that increase employment (like the construction of new public works) while also reducing taxes to stimulate consumer demand.
  2. During periods of unusually high economic growth and full employment, governments may use contractionary fiscal policy to “tap the brakes” on an expanding economy, especially when rising inflation is a concern. Contractionary fiscal policy involves reducing government spending and increasing taxes. (When this type of fiscal policy is implemented during an economic slowdown, it is referred to as “austerity policy” and enables governments to save money.)
  3. Fiscal policy can also be said to be neutral when the level of government spending in relation to tax revenue is stable over time. This could be considered the “default” policy when an economy is neither rapidly expanding nor contracting, and the government doesn’t intend to actively intervene in the economy.

What Is the Difference Between Fiscal Policy and Monetary Policy?

Fiscal policy and monetary policy are related in that they’re two major tools available to governments to influence the economy. While their objectives may be broadly similar, how they work and how they’re administered are quite different.

  • While fiscal policy is concerned with how money is spent and collected by the government, monetary policy is concerned with the overall supply of money within the economy.
  • Fiscal policy is usually set by the executive and legislative functions. Monetary policy is generally determined by central banks.
  • Governments adjust fiscal policy by changing levels of taxation and spending in order to stimulate (or discourage) consumer spending and maintain healthy levels of employment and inflation. The key metric here is aggregate demand.
  • Central banks adjust monetary policy by buying and selling treasury bonds to expand or contract the amount of currency in circulation, and by raising or lowering the interest rate and reserve ratio (i.e. the amount of money banks are required to hold onto at any given time) in order to stimulate (or discourage) lending by banks.

What Are Some Criticisms of Fiscal Policy?

Compared to monetary policy, fiscal policy is slower to enact and more prone to political influence.

  • While the budget and appropriations process may take many months (especially in times of divided government), central banks can adjust interest rates every month in response to new economic conditions.
  • Furthermore, political leaders may be tempted to use fiscal policy to produce short-term economic and political gains at the expense of the economy’s long-term health, often in the form of tax cuts.

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