Fiscal Policy

“Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy. It is the sister strategy to monetary policy with which a central bank influences a nation's money supply. These two policies are used in various combinations in an effort to direct a country's economic goals.

Before the Great Depression in the United States, the government's approach to the economy was laissez faire. But following the Second World War, it was determined that the government had to take a proactive role in the economy to regulate unemployment, business cycles, inflation and the cost of money. By using a mixture of both monetary and fiscal policies (depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another), governments are able to control economic phenomena.”

The fiscal policy together with the monetary policy are the macroeconomic tools used by governments to manage the economy. Through fiscal policy the government can choose how to form it’s budget and how to change the total or the composition of the level of expenditures and revenues in order to manage the growth of demand in economy.

The laissez faire system used in the US before the Great Depression suggested no state involvement in the economy, relying on market forces to allocate goods and resources and to determine prices. However, government action through the mix of both fiscal and monetary policies proved to achieve economic objectives of price stability, full employment and economic growth.

How Fiscal Policy Works

“Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money.”

Depending on which phase of the business cycles occurs at a certain time in an economy, fiscal policy can be considered as being either expansionary or contractionary. Expansionary fiscal policy means an increase in overall spending in the economy by lowering taxes and giving people more money to spend. On the other hand, contractionary fiscal policy will slow down the economy by reducing consumption through increased taxation, cutting down on people’s income.

Partially accepted during the 1930s, Keynes’s theory seemed to be confirmed when World War II caused huge government spending, making suppliers to increase production and thus increase income.