What is Fiscal Policy?
Fiscal policy refers to the budgetary policy of the government, which involves the government controlling its level of spending and tax rates within the economy. The government uses these two tools to influence the economy. It is the sister strategy to monetary policy. Although both fiscal policy and monetary policy are related to government revenues and expenditures and both seek to correct situations of excess or deficient demand in the economy, they do so in very different ways.
Origins of Fiscal Policy
Before the Great Depression, governments across the world followed the policy of Laissez-faire (or Let it be). This approach to the economy was based on the teachings of classical economists such as Adam Smith and Alfred Marshall. Classical economists believed in the power of the invisible hand of the market. They were of the opinion that the government should not interfere in the economy, as any interference in the market was uncalled for.
However, the 1929 stock market crash that ushered in the Great Depression fundamentally changed the course of economic thought. The Depression resulted in low economic demand along with high unemployment. Classical economics could not provide any solution to the crisis.
In 1936, British economist John Maynard Keynes published “The General Theory of Employment, Interest, and Money” (known simply as “The General Theory”). In it, Keynes called for an increase in government spending to combat the recessionary forces in the economy. He believed that an increase in government spending would bring about an increase in demand for commodities in the market.
The Second World War provided empirical evidence of Keynes’ theory. Nations across the world increased government expenditure in order to build their armed forces. The rise in government expenditure saw massive growth in employment and an increase in demand for commodities in the market. In fact, the Second World War is often credited with bringing Europe out of the Great Depression.
How Does Fiscal Policy Work?
Proponents of Fiscal Policy utilization believe that public finance can influence inflation and employment by manipulating two key variables:
- The level of government spending or the amount of money the government spends
- The tax rate or the amount of money the government earns
In times of economic contraction, such as the Great Depression in the 1920s and 1930s and the 2008-2009 financial crisis, the government engages in Expansionary Fiscal Policy. This involves a reduction in taxes and an increase in government spending. Both measures are meant to stimulate the economy and increase the level of activity within the economy. During a recession, producers and consumers both lose faith in the market. Thus, consumers reduce consumption and producers cut production. As a result, the economy stagnates.
In 2009, when Barack Obama took office as President of the United States, he signed the American Recovery and Reinvestment Act (ARRA). The ARRA was a stimulus package that involved government spending amounting to almost $800 billion. The ARRA was meant to create jobs, boost demand, and improve faith in the economy as a whole. Many have argued (mostly fiscal conservatives) that Obama could have achieved a similar result by cutting taxes
If instead, the government faces a situation of high inflation characterized by excess demand in the market, it can engage in contractionary fiscal policy. For example, the government can impose new taxes and raise existing tax rates. This will reduce disposable income, which will cause consumption and investment to fall, thereby correcting the situation of excess demand.
Taxes vs. Government Spending
According to classical Keynesian economics (from the General Theory of Employment), a reduction (or increase) in taxes and an increase (or reduction) in government spending affect the economy in similar ways. However, the government may choose to utilize one over the other for various reasons.
For example, raising taxes tend to make governments extremely unpopular. Hence, most governments, when faced with inflation and excess demand in the market, tend to lower government spending instead of raising taxes.
Video Explanation of Fiscal Policy
Watch this short video to quickly understand the main concepts covered in this guide, including the origins of fiscal policy and how fiscal policy is used to influence the economy.
CFI is the official provider of the global Commercial Banking & Credit Analyst (CBCA)™ certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional resources below will be useful: