Fiscal policy leverages government spending and tax policies to shape economic conditions, especially macroeconomic aspects such as aggregate demand, employment, inflation, and growth.
During economic downturns, the government can lower tax rates or escalate expenditure to boost demand and stimulate economic activity. Conversely, to counter inflation, it can hike taxes or decrease spending to cool the economy.
Fiscal policy often contrasts with monetary policy, managed by central banks rather than elected government officials.
Key Insights:
- Impact on Economic Conditions: Fiscal policy influences aggregate demand, employment levels, inflation rates, and economic growth.
- Keynesian Foundation: Rooted in the ideas of the British economist John Maynard Keynes, who advocated for government intervention to stabilize the business cycle.
- Types of Policies: Expansionary fiscal policy involves cutting taxes or increasing spending, while contractionary fiscal policy entails raising taxes or cutting spending.
Understanding Fiscal Policy
U.S. fiscal policy predominantly aligns with Keynesian economics. Keynes argued that economic recessions stem from a drop in consumer and business spending, and economic output could be stabilized through strategic government intervention in taxation and spending.
Keynes’ theories emerged from the Great Depression, challenging classical economics’ notions of self-correcting markets, and led to significant policies like the New Deal.
Dynamic Behavior in the Private Sector
Keynesian economics points out the volatile nature of private sector spending, prone to psychological and emotional influences such as fear and overconfidence. This can lead to either deep recessions or overheated economies.
Therefore, rational government spending and taxes can balance the fluctuations in private sector activities, ensuring stable economic growth.
Corrective Action by The Government
To counteract economic downturns, the government can increase spending or reduce taxes. Conversely, to manage overly optimistic private spending, it may limit its expenditure or increase taxes. This way, the government can run budget deficits during downturns and surpluses during growth phases.
Examples of Fiscal Policy
Real-World Application During the Great Depression
During the 1930s, unemployment soared in the U.S., leading to rampant poverty. President Franklin D. Roosevelt’s New Deal applied expansionary fiscal policy—creating New Deal agencies and programs such as the WPA and Social Security—which, alongside wartime spending, eventually pulled the U.S. out of the Depression.
Types of Fiscal Policies
Expansionary Policy and Tools
In times of recession, the government might introduce tax rebates or increase spending on projects like highway construction to foster growth, lower unemployment, and initiate a positive feedback loop of rising wages and increased consumer spending.
Expansionary policies often involve deficit spending, where expenditures surpass income, usually combining tax cuts with heightened spending.
Contractionary Policy and Tools
To battle inflation and expansion-related symptoms, the government might increase taxes, reduce public spending, and cut public sector wages. Contractionary policies, typically featuring budget surpluses, are less common due to their political unpopularity.
The Downsides of Expansionary Policy
Critics caution against mounting deficits from expansionary policies, which may burden future growth and necessitate austerity measures. There is also a risk of the government outspending the private sector, leading to inefficiencies.
Additionally, expansionary policies can become overly popular, difficult to reverse, and ultimately lead to inflation and asset bubbles, necessitating contractionary measures by the central bank.
Fiscal Policy vs. Monetary Policy
Fiscal policy entails the government’s use of taxes and spending to influence economic activity, while monetary policy, managed by the Federal Reserve, revolves about regulating liquidity and the money supply to maintain employment and stable prices.
Who Manages Fiscal Policy?
In the U.S., both executive and legislative branches are responsible for fiscal policy, with the President’s advice entwined with the Secretary of the Treasury and the Council of Economic Advisers, while Congress authorizes taxes and spending.
Main Tools of Fiscal Policy
Primary tools include adjustments in taxation and government spending levels, where reducing taxes and increasing spending stimulate growth, and raising taxes and cutting spending can cool down an overheating economy.
Impact on the Public
The effects are unevenly distributed, often influenced by policymakers’ goals. For example, tax reductions may predominantly benefit the middle class, while spending decisions, like building infrastructure versus specialized projects, affect different workforce sectors.
A Delicate Balance
Policymakers constantly debate the extent of government involvement in the economy, seeking a balance that sustains economic vitality for public well-being.
The Bottom Line
U.S. fiscal policy, through adjustments in tax rates and government spending, aims to foster a robust economy. Governments may lower taxes or increase spending during economic slowdowns or control growth through opposite measures during high economic activity, often recouring to monetary policy interventions during high inflation periods.
Related Terms: monetary policy, Keynesian economics, aggregate demand, business cycle, expansionary policy, contractionary policy.
References
- International Monetary Fund. “What Is Keynesian Economics?”
- Up to U.S. “What Is Fiscal Policy?”
- Board of Governors of the Federal Reserve System. “Monetary Policy”.
- Board of Governors of the Federal Reserve System. “Policy Tools”.
