Fiscal Policy
Fiscal policy involves the government
changing the levels of taxation and
government spending in order to
influence Aggregate Demand (AD) and
the level of economic activity. AD is the
total level of planned expenditure in an
economy.
Purpose of Fiscal Policy
Stimulate economic growth in a
period of a recession.
Keep inflation low (UK government
has a target of 2%)
Basically, fiscal policy aims to
stabilize economic growth, avoiding a
boom and bust economic cycle.
Fiscal policy is often used in conjunction
with Monetary Policy. In
fact, governments often prefer monetary
policy for stabilizing the economy.
Must Read: Economics: The Basics
Types of Fiscal Policy
There are two basic types of fiscal
policy. The first, and most widely-used,
is expansionary. Its objective is to
stimulate the economy and create more
growth. This is most critical at the
contraction phase of the business
cycle when voters are clamoring for
relief from a recession.
The government spends more, or cuts
taxes or both if it can. The idea is to put
more money into consumers hands, so
they spend more. This jumpstarts
demand, which keeps businesses
running,
Expansionary fiscal policy is usually
impossible for state and local
government because they often are
mandated to keep a balanced budget. If
they havent created a surplus during the
boom times, they usually have to cut
spending to match lower tax revenue
during a recession making it worse.
The second type, contractionary fiscal
policy, is rarely used. Thats because its
objective is to slow economic growth.
One reason only, and thats to stamp
out inflation. Thats because the long-
term impact of inflation can damage the
standard of living as much as a
recession.
The tools of contractionary fiscal policy
are used in reverse: taxes are increased,
and spending is cut. Monetary policy is
very effective in preventing inflation.
Also Read: Elements of Economics
Tools of Fiscal Policy
The first tool is taxation, whether of
income, capital gains from investments,
property, sales or just about anything
else. Taxes provide the major revenue
source that funds the government. The
downside of taxes is that whatever or
whoever is taxed has less income to
spend themselves. That makes taxes
very unpopular.
The second tool is spending. The
government provides subsidies, transfer
payments including welfare programs,
contracts to perform all kinds of public
works, and of course salaries to
government employees to name just a
few. The reason government spending is
a tool is that whatever or whoever
receives the funds has more money to
spend, thus
driving demand and economic growth.
Have a Look at: History of Money
Fiscal Policy vs. Monetary Policy
Monetary policy is when a
nations central bank increases
the money supply, using expansionary
monetary policy, or decreases it,
using contractionary monetary policy. It
has many tools it can use, but it
primarily relies on raising or lowering
the Fed funds rate. This benchmark
rates then guides all interest rates.
When interest rates are high, the money
supply contracts, the economy cools
down, and inflation is prevented. When
interest rates are low, the money supply
expands the economy heats up, and a
recession is avoided usually.
Monetary policy works faster than fiscal
policy. The Fed can simply vote to raise
or lower rates at its regularly FOMC
meeting. It may take about six months
for the effect to percolate throughout
the economy.
Dont Miss: Foreign Trade Policy (FTP)
2015 20
Brief history of fiscal policy
Keynes advocated the use of fiscal
policy as a way to stimulate
economies during the great
depression.
Fiscal Policy was particularly used in
the 50s and 60s to stabilize economic
cycles. These policies were broadly
referred to as Keynesian
In the 1970s and 80s governments
tended to prefer monetary policy for
influencing the economy. Fiscal
policy became more prominent during
the great depression of 2008-13.
