Fiscal Policy Definition Examples Tools How It Works

Fiscal Policy Definition

It is the other half of monetary policyMonetary PolicyMonetary policy refers to the steps taken by a country’s central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc.read more which the central bank enforces. Both these macroeconomic measures are imposed in alignment with one another for economic stability.

Key Takeaways

Fiscal policy is a government-initiated measure to alter tax rates and government spending for creating a macro-level impact on the nation’s economy.It is often implemented along with the monetary policy which is implemented by the central bank of a nation.The contractionary fiscal policies are applicable to control the situation like inflation. While to correct the economic contraction such as deflation, expansionary fiscal policies are adopted.The policy has originated from the Keynesian theory, which challanged classical economists who believe that an economy has a self-correction mode.

Fiscal Policy Explained

Fiscal policy is a corrective measure of a government to check uncontrolled economic expansion or contraction. If economic expansion gets out of hand, it will lead to hyperinflation, while unchecked contraction can push an economy towards deflationDeflationDeflation is defined as an economic condition whereby the prices of goods and services go down constantly with the inflation rate turning negative. The situation generally emerges from the contraction of the money supply in the economy.read more. The two powerful weapons used by the government to achieve economic stability are tax rates and public spending.

Expand, peak, contract and trough are prominent phases of an economic cycle. The purpose of fiscal policy is to bring about an economic balance throughout this cycle and minimize its ill effects on citizens. Therefore, it is an essential measure adopted parallel to the monetary policy for a nation’s welfare and development.

When it comes to economic contraction such as recession, the government implements expansionary policyExpansionary PolicyExpansionary policy is an economic policy in which the government increases the money supply in the economy using budgetary tools. It is done by increasing the government spending, cutting the tax rate to increase disposable income etc.read more to ensure that the consumers and firms have enough money. As a result, the fiscal multiplier can increase the GDP higher than initial public spending due to the ripple effect.

Suppose, during the recession, the government initiated the construction of hospitals. When hired workers spend on consumption, it will generate more business, leading businesses to hire more. The newly hired workforce will also spend their salary, leading to further business growth, inducing a ripple effect. Conversely, the government imposes contractionary policiesContractionary PoliciesContractionary monetary policy is the type of economic policy that is basically used to deal with inflation and it also involves minimizing the fund’s supply in order to bring an enhancement in the cost of borrowings which will ultimately lower the gross domestic product and moderate or decrease inflation too.read more when the nation faces adversities such as hyperinflation owing to over expansion.

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Economic Theory Behind Fiscal Policy

The phase before the great depression of 1930 experienced a firm belief in the classical model. The ideology was that the economy is free-flowing. No matter the circumstances, the economy is self-adjusting and reinstates itself to an optimal level of GDP.

Moreover, the classical economists assumed that the economy operates at full employment where the resources are utilized at their total capacity.

Fiscal policy was brought forward by the famous economist from Britain, John Maynard Keynes, in 1930, when the great depressionGreat DepressionThe Great Depression refers to the long-standing financial crisis in the history of the modern world. It began in the United States on October 29, 1929, with the Wall Street Crash and lasted till 1939.read more took the world by storm. The Keynesian theoryKeynesian TheoryKeynesian Economics is a theory that relates the total spending with inflation and output in an economy. It suggests that increasing government expenditure and reducing taxes will result in increased market demand and pull up the economy out of depression.read more challenged classical economists. It proposed that a free market doesn’t have a self-balancing system to overcome economic debacles.

Rather, the market demand is influenced by the economic forces such as tax rates and government spending. Thus, any changes in these forces can increase or decrease the aggregate demand in the economy.

Contractionary Fiscal Policy and Tools

When there is an inflationary wave in the economy and the GDP is growing fast, the value of money depletes. Thus, the government adopts a contractionary fiscal policy to reduce the aggregate demandAggregate DemandAggregate Demand is the overall demand for all the goods and the services in a country and is expressed as the total amount of money which is exchanged for such goods and services. It is a relationship between all the things which are bought within the country with their prices.read more and consumer expenditure by lowering their disposable incomeDisposable IncomeDisposable income is an important mechanism to measure household incomes, and includes all sorts of income such as wages and salaries, retirement income, investment gains. In other words, it is the amount of money left after paying off all the direct taxes.read more.

The two contractionary methods undertaken to curtail excessive inflation include:

Increase in Tax Rates: The government levies heavy taxes on products, services, and incomes of individuals or businesses to reduce a consumer’s purchasing power.Decrease in Government Spending: The other measure involves cutting down government’s public expenditure. Government spends on subsidies, wages and public welfare projects like roads, hospitals or schools. Reduced spending leads to lower employment, leaving less money in the hands of people.

Expansionary Fiscal Policy and Tools

The government takes up expansionary measures when there is an economic slowdown. Stagnant or recession hit economy causes unemployment, falling GDP, low aggregate demand and reduced consumer spending.

Thus, to enable economic growth and recovery, the government takes the following two actions:

Decrease in Tax Rates: The government cuts down direct and indirect tax rates to allow more money in the hands of consumers. This indeed enhances their purchasing power and the aggregate demand for goods and services. As a result, the GDP improves.Increase in Government Spending: Also, by increasing public spending, the government ensures a higher level of employment to increase consumption.

Fiscal Policy Examples: Do they really work?

#1 – Great Recession (December 2007 – June 2009)

The US had faced a great recession from December 2007 to June 2009. This report from Business Insider recalls how the great recession shook the US. It had resulted from the housing market crash, prevailing weak regulations, low-interest rates, subprime mortgages, and easy lending procedures.

To overcome the crisis, the federal government imposed the American Recovery and Reinvestment Act (ARRA) in 2009 as an expansionary fiscal policy measure. It initiated tax cuts, unemployment benefits, massive government spending and accessible loan facility.

Simultaneously the Troubled Asset Relief Program (TARP) was run to control the situation that involved buying toxic assets worth $700. Thus, both the fiscal and monetary policies together proved effective in arresting the crisis. However, while the stock market showed a rebound in 2009, the overall economic recovery took years to arrive.

#2 – Europe’s Covid-19 Package

In response to the crippling effects of the pandemic, European governments enhanced their public spending on medical resources, subsidies, employment generation, etc. Another measure was cutting down several tax rates and social security contributions.

For example, in Belgium, the immediate fiscal rescue involved spending 3.1 billion euros. The temporary unemployment relief worth 0.6 billion euros came to the rescue of those who were temporarily laid off amidst the pandemic.

Criticisms

Also, when the government aims to improve the employment level, it is possible that such a policy may not benefit the targeted unemployed personnel due to a lack of skills.

Therefore, the policy cannot be the sole solution to crisis-hit economies. It must be applied in coordination with monetary policies. At the same time, intervening policies must be revoked timely to avert the over-dependency of the economy. After a while, it should be allowed to overcome its problems on its own.