Fiscal policy involves the government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity. AD is the total level of planned expenditure in an economy.
Purpose of Fiscal Policy
- Stimulate economic growth in a period of a recession.
- Keep inflation low (UK government has a target of 2%)
- Basically, fiscal policy aims to stabilize economic growth, avoiding a boom and bust economic cycle.
Fiscal policy is often used in conjunction with Monetary Policy. In fact, governments often prefer monetary policy for stabilizing the economy.
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Types of Fiscal Policy
There are two basic types of fiscal policy. The first, and most widely-used, is expansionary. Its objective is to stimulate the economy and create more growth. This is most critical at the contraction phase of the business cycle when voters are clamoring for relief from a recession.
The government spends more, or cuts taxes or both if it can. The idea is to put more money into consumers’ hands, so they spend more. This jumpstarts demand, which keeps businesses running,
Expansionary fiscal policy is usually impossible for state and local government because they often are mandated to keep a balanced budget. If they haven’t created a surplus during the boom times, they usually have to cut spending to match lower tax revenue during a recession — making it worse.
The second type, contractionary fiscal policy, is rarely used. That’s because its objective is to slow economic growth. One reason only, and that’s to stamp out inflation. That’s because the long-term impact of inflation can damage the standard of living as much as a recession.
The tools of contractionary fiscal policy are used in reverse: taxes are increased, and spending is cut. Monetary policy is very effective in preventing inflation.
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Tools of Fiscal Policy
The first tool is taxation, whether of income, capital gains from investments, property, sales or just about anything else. Taxes provide the major revenue source that funds the government. The downside of taxes is that whatever or whoever is taxed has less income to spend themselves. That makes taxes very unpopular.
The second tool is spending. The government provides subsidies, transfer payments including welfare programs, contracts to perform all kinds of public works, and of course salaries to government employees — to name just a few. The reason government spending is a tool is that whatever or whoever receives the funds has more money to spend, thus driving demand and economic growth.
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Fiscal Policy vs. Monetary Policy
Monetary policy is when a nation’s central bank increases the money supply, using expansionary monetary policy, or decreases it, using contractionary monetary policy. It has many tools it can use, but it primarily relies on raising or lowering the Fed funds rate. This benchmark rates then guides all interest rates. When interest rates are high, the money supply contracts, the economy cools down, and inflation is prevented. When interest rates are low, the money supply expands the economy heats up, and a recession is avoided — usually.
Monetary policy works faster than fiscal policy. The Fed can simply vote to raise or lower rates at its regularly FOMC meeting. It may take about six months for the effect to percolate throughout the economy.
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Brief history of fiscal policy
- Keynes advocated the use of fiscal policy as a way to stimulate economies during the great depression.
- Fiscal Policy was particularly used in the 50s and 60s to stabilize economic cycles. These policies were broadly referred to as ‘Keynesian’
- In the 1970s and 80s governments tended to prefer monetary policy for influencing the economy. Fiscal policy became more prominent during the great depression of 2008-13.