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Fiscal Policy: What It Is, Why It Matters, and Examples

File Photo: Fiscal Policy: What It Is, Why It Matters, and Examples
File Photo: Fiscal Policy: What It Is, Why It Matters, and Examples File Photo: Fiscal Policy: What It Is, Why It Matters, and Examples

What’s fiscal policy?

Fiscal policy influences macroeconomic circumstances through government spending and tax policies. These include aggregate demand, employment, inflation, and economic growth.

The government may decrease taxes or increase expenditures in a recession to boost demand and activity. It may hike rates or reduce spending to fight inflation and chill the economy.

Elective officials do not set monetary policy; instead, central bankers do.

Knowledge of Fiscal Policy

British economist John Maynard Keynes (1883–1946) heavily influenced U.S. fiscal policy. He thought that a lack of business investment and consumer spending caused recessions.

Keynes thought governments could manage economic production by modifying spending and tax policies to compensate for private sector deficiencies, stabilizing the business cycle.1

The Great Depression challenged classical economics’ view that economic fluctuations were self-correcting, prompting his views. Keynes’ ideas influenced the U.S. New Deal, including significant social welfare spending and public works initiatives.

According to Keynesian economics, aggregate demand or spending promotes economic growth. Consumer spending, corporate investment, net government expenditure, and net exports comprise aggregate demand.

Variable Private Sector Behavior

Keynesian economists believe private sector aggregate demand is too volatile and dependent on psychological and emotional elements to support economic development.1

Consumer and business pessimism, anxiety, and uncertainty can cause recessions and depressions. In addition, public sector overconfidence in good times can cause inflation and overheating.

Keynesians think government taxes and expenditures can be reasonably controlled to balance private sector consumption and investment spending and stabilize the economy.

Government Fiscal Corrective Action

When private sector spending drops, the government can spend more and tax less to boost aggregate demand. When the private sector is excessively enthusiastic and spends too much, too fast on consumption and new investment projects, the government can cut spending or tax more to lower aggregate demand.

The government should run huge budget deficits during economic downturns and surpluses during economic growth to stabilize the economy. These measures are called expansionary or contractionary fiscal policies.

Fiscal Policy Example

In the 1930s, 25% of Americans were unemployed, and millions waited in long lines. Suffering felt interminable. Franklin D. Roosevelt implemented an expansionary fiscal strategy. He introduced his new deal immediately after taking office. The program established new government agencies, the WPA employment program, and the ongoing Social Security program. These and his World War II expansionary policy expenditures helped end the Depression.

Fiscal Policy Types

Expanding Policy and Tools

To demonstrate the impact of fiscal policy on the economy, assume a recession. The government may provide tax incentives to boost demand and boost economic development.

Lower taxes mean more money to spend or invest, which boosts demand. This demand drives employers to recruit more, reducing unemployment and intensifying labor rivalry. This raises earnings and gives customers more money to spend and invest. This is a positive feedback loop or virtuous cycle.

Instead of cutting taxes, the government may boost expenditures without raising taxes. Building new roadways might boost demand and GDP by increasing jobs.

Expansionary fiscal policy often involves deficit expenditures. Government deficit spending happens when spending exceeds tax and other revenue. Tax cuts and increased expenditures usually cause deficits.

Tools and Policy Contraction

In response to rising inflation and expansionary symptoms, governments may use contractionary fiscal policy, even causing a temporary recession, to restore economic equilibrium.

To do this, the government raises taxes, cuts public spending, and eliminates public sector employment or salaries.

Contractionary fiscal policy has budget surpluses, whereas expansionary budgetary policy has deficits. It’s politically unpopular; hence, this policy is rarely employed.

Thus, public officials confront different incentives to expand or constrict fiscal policy. Therefore, contractionary monetary policy is preferable to curb unsustainable growth. The Federal Reserve uses monetary policy to control inflation by raising interest rates and limiting the money and credit supply.

The U.S. government influences economic activity through tax rates and spending.

Expansionary Policy Drawback

Increasing deficits are one objection against expansionary fiscal policies. Critics argue that excessive government spending might hinder growth and lead to harmful austerity measures.

Many economists doubt how expansionary fiscal policies work. The argument is that government expenditure may easily overshadow private-sector investment.

Some economists argue expansionary policy is dangerously popular. Reversing fiscal stimulus is politically challenging. Voters prefer low taxes and governmental expenditure, regardless of macroeconomic implications.

Due to political incentives, politicians favor persistent deficit spending that can be justified as favorable for the economy.

Economic growth can become unsustainable. As wages rise, inflation and asset bubbles arise. When loan bubbles burst, high inflation and widespread defaults can hurt the economy. This danger causes governments (or central banks) to reverse direction and shrink the economy.

Fiscal vs. Monetary Policy

The government controls fiscal policy. Taxes and government spending stimulate or hinder economic development.

The Federal Reserve Board in the U.S. manages monetary policy, which involves adjusting the money supply to boost or decrease liquidity. The Federal Reserve Board said these moves will “promote maximum employment, stable prices, and moderate long-term interest rates—the economic goals the Congress has instructed the Federal Reserve to pursue.”

The Fed utilizes four monetary policy tools to shift liquidity, consumer spending, and borrowing:

  • Open-market securities trading
  • Loaning to depository institutions via a discount window
  • Increasing or decreasing discount rates
  • Raising or reducing federal funds rates
  • Setting bank reserve requirements
  • Central bank liquidity swaps
  • Financing via overnight repurchase agreements

Who handles fiscal policy?

Both the executive and legislative branches oversee fiscal policy in the US. While the President and Secretary of the Treasury are the most prominent executive posts, modern presidents rely on a Council of Economic Advisers.

The U.S. Congress authorizes taxes, adopts legislation, and allocates expenditures for fiscal policy through its power of the purse. House and Senate members participate, deliberate, and approve this procedure.

What are the main fiscal policy tools?

Governments impact the economy with fiscal policy—mostly taxes and government expenditure reforms. To boost growth, taxes are decreased, and expenditures are increased. This usually requires government debt. Raising taxes and cutting spending may cool an overheated economy.

How does fiscal policy affect people?

Fiscal policy often affects people differently. Depending on politicians ‘ political views and ambitions, tax cuts may solely affect the middle class, the most significant economic group. During economic collapse and increased taxes, this sector may pay more than the wealthy upper class.

When a government adjusts spending, just a particular group may be affected. For instance, building a new bridge will employ hundreds of construction workers. However, spending money on a new space shuttle benefits only a limited, specialized pool of specialists and enterprises, not increasing aggregate employment.

Should the government intervene in the economy?

Policymakers struggle to decide how much direct government intervention in the economy and individuals’ economic lives is appropriate. The government has interfered in US history to varying degrees. Most people agree that a dynamic economy that supports the population’s economic well-being requires some government participation.

Bottom Line

The U.S. government controls fiscal policy to preserve a healthy economy. Government expenditure and tax rate modifications boost economic growth.

When the economy slows, the government may cut taxes or increase expenditure on government programs.

When inflation looms, a hot economy may raise taxes or cut expenditures. Neither is appealing to politicians seeking reelection. Thus, using monetary policy, the government relies on the Fed to lower inflation.

Conclusion

  • Fiscal policy involves government spending and tax policies that impact economic circumstances.
  • The British economist John Maynard Keynes shaped fiscal policy.
  • Keynes proposed that governments should control economic production and stabilize the business cycle rather than relying on market forces.
  • An expansionary fiscal strategy involves reducing taxes or increasing expenditures to boost demand and economic growth.
  • A contractionary fiscal policy aims to lower inflation by increasing rates or reducing spending.

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