Fiscal Policy


Fiscal Policy refers to the use of the spending levels and tax rates to influence the economy. It is the sister strategy to monetary policy which deals with the central bank’s influence over a nation’s money supply. The governing bodies use combinations of both these policies to achieve the desired economic goals. Thus, the essential tools of fiscal policy are taxing and spending. [1]

As the American economy slid into recession in 1929, economists relied on the Classical Theory of economics, which promised that the economy would self-correct if government did not interfere. But as the recession deepened into the Great Depression and no correction occurred, economists realized that a revision in theory would be necessary. John Maynard Keynes developed Keynesian Theory, which called for government intervention to correct economic instability. Keynes recommended that, during periods of recession, the government should increase spending in order to “prime the pump” of the economy. At the same time, he recommended, it should decrease taxes in order to give households more disposable income with which they can buy more products. Through both methods of fiscal policy, the increase in aggregate demand stimulates firms to increase production, hire workers, and increase household incomes to enable them to buy more. Keynes advocated the opposite positions during times of rapid inflation. Keynes presented his ideas in a book called The General Theory of Employment, Interest and Money, published in 1936. [2]

The fiscal policy is controlled by those people in the government who have control over the tax rates and government spending. It varies from country to country. The individuals who have control over the budget are referred to as the fiscal authority. In the United States, it is held by the executive and legislative branches; whereas in Europe, there are varied models with the power, mostly, lying in the hands of the prime minister or the finance minister and the parliament with the degree of power of either bodies changing through time.


Discretionary Fiscal Policy and Automatic Stabilizers

The government exercises fiscal policy to prevent economic fluctuations from taking place. When actions are undertaken to minimize economic fluctuations, it is known as discretionary fiscal policy. Discretionary fiscal policy is employed when an increase in unemployment and inflation is observed. [3]

Another element that can come into play during economic fluctuations is Automatic Stabilizers. They are taxes and transfers that automatically change with changes in economic conditions in a way that dampens economic cycles. For example, at times of economic downturns, the amount of money spent on food stamps automatically rises as more people apply for it or the rules are eased. The additional spending generated by the food stamps helps to soften the downturn for the individuals receiving the help, and also benefits the businesses and employees where the money is spent. [4]


Types of Fiscal Policies

There are two types of fiscal policy: expansionary and contractionary. The objective of expansionary fiscal policy is to reduce unemployment. Thus, an increase in government spending and/or decrease in taxes are implemented that results in better GDP and reduced unemployment. However, it can also cause some inflation. On the other hand, the objective of contractionary fiscal policy is to reduce inflation. Therefore, a decrease in government spending and/or an increase in taxes are implemented that leads to decreasing inflation. However, it can also trigger some unemployment. [5] In other words, fiscal policy that increases aggregate demand directly through an increase in government spending is typically called expansionary or loose. By contrast, fiscal policy is often considered contractionary or tight if it reduces demand via lower spending.


Effects of Fiscal Policy

The objectives of fiscal policy vary with duration and economy of application. In the short term, governments may focus on macroeconomic stabilization with aims of stimulating an ailing economy, combating rising inflation, or helping reduce external vulnerabilities. In the longer term, the aim may be to foster sustainable growth or reduce poverty with actions on the supply side to improve infrastructure or education. Although these objectives are common among countries, their relative importance differs depending on the country circumstances. In the short term, priorities may reflect the business cycle or response to a natural disaster while in the longer term; the catalysts can be development levels, demographics, or resource endowments. [6]

The macroeconomic effects of fiscal policy have to be studied under two circumstances: one with reduced expenditure (less spending) and the other with reduced revenue (less taxes). The results of lessened expenditure have, in general, a small effect on GDP; and they don’t impact private consumption significantly. Although they do have a negative effect on private investment, a varied effect on housing prices, lead to a quick fall in stock prices and depreciation of the real effective exchange rate.

Reduced taxes have the inverse outcomes as they have positive (although lagged) effects on GDP and private investment; have a positive effect on both housing and stock prices; and lead to appreciation of the real effective exchange rate. [7]


Limits of Fiscal Policy

Fiscal policy is a powerful tool that can maintain the economy in perfect balance. However, putting them into practice is quite a difficult task because of various reasons.

Government spending levels can’t be altered with that easily. A major chunk of government funds is devoted to health care, social service, and veterans’ benefits and such. Thus, changes in expenditure generally must come from the small part of the budget that includes discretionary spending. This gives the government less leeway for increasing or lowering spending.

Another inhibiting factor is working with estimations. When lawmakers put fiscal policies in place, they base their decisions partly on the past behaviors of individuals. It is risky to assume that people will, for example, respond the same way to a tax cut in the future as they have in the past.

Although changes in fiscal policy affect the economy, changes take time. By the time the policy takes effect, the economy might be moving in the opposite direction. In these cases, fiscal policy would only add to the new trend, instead of correcting the original problem.

The pressure that people in authority experience of pleasing the citizens hinders fiscal policy as well. Expansionary fiscal policy (reduced taxes) is a popular choice, but it can’t be applied in every situation, and thus, puts the authorities in a predicament when contractionary policy has to be applied, and instills fear a backlash from the voters. Furthermore, execution of fiscal policy isn’t a simple task. It requires a coordinated effort from multiple pockets of the government which is very difficult to make happen. In addition, a problem prevalent in one part of the country may not be as troublesome in another or possibly the opposite of that. In addition, in order to be effective, the fiscal policy has to be in coordination with the monetary policies of the central bank as well. ­­[2]



  2. Economics: Principles in action by Arthur Sullivan & Steven M. Sheffrin – Pearson Prentice Hall – 2003
  6. What is Fiscal Policy by Mark Horton & Asmaa El-Ganainy – Finance & Development, Volume 46, Number 2 – IMF – June 2009
  7. The Macroeconomic Effects of Fiscal Policy by António Afonso and Ricardo M. Sousa – Working Paper #991 – European Central Bank – January 2009

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