What is Fiscal Policy?

Fiscal policy is kind of like the gas and brake pedals in a car…

The government can use one type of fiscal policy (the brake pedal) to slow economic growth when it’s moving too quickly. It can use the other type (the gas pedal) to give the economy a boost when it’s flagging.

The purpose of fiscal policy is to keep economic growth at a reasonable level. The government doesn’t want the economy to grow too slowly, as this can result in a recession and high levels of unemployment. But it also doesn’t want the economy to grow too quickly, because that can mean high inflation and a rapidly increasing cost of living. This could also cause an asset bubble, which is when the prices of assets, such as houses or stocks, become over-inflated.

In the U.S., fiscal policy is typically carried out through the federal budget that Congress passes and the president signs into law. First, the president submits his proposed budget to Congress, and then legislators review and amend the budget to their liking. The federal budget consists of mandatory spending (initiatives the federal government is legally obligated to fund), such as Social Security and Medicare, and discretionary spending (initiatives the government chooses to support). Fiscal policy is part of discretionary spending.

Keeping the economy on track is one of the primary roles of government. Politicians disagree considerably about how much the government should intervene in the marketplace, but most agree that some government involvement is necessary to maintain a healthy economy.

There are two main types of fiscal policy: expansionary and contractionary. As the names suggest, expansionary fiscal policy is meant to stimulate economic growth, while contractionary fiscal policy aims to slow it down.

There are two primary tools at the government’s disposal when it comes to setting fiscal policy: taxes and spending. Both tools can be used for expansionary or contractionary policy — They’re just applied differently in each case.

The government uses expansionary fiscal policy to boost the economy in a time of decline or particularly sluggish growth. The goal is to get people to spend more money. To do this, the government tries to get more cash into the hands of consumers either by bumping up government spending or by cutting taxes.

The government might increase spending on infrastructure, which creates jobs. Or it might spend more on welfare programs, giving money directly to families. With tax cuts, some policies might target the middle class, in hopes of getting them to spend more money. Others might target businesses in the hopes that they will invest in growth and hire more workers.

People with different political ideologies disagree on which method of expansionary fiscal policy is best. Those who believe in supply-side economics, also called “trickle-down” economics, tend to argue that lowering taxes makes businesses more likely to invest in expansion and hire more employees. Those workers, in turn, spend their wages, which leads to further economic growth.

Advocates of demand-side economics, on the other hand, argue that increasing demand for goods and services is what drives the economy. They argue that increasing government spending can help drive up employment and put money into the hands of consumers, which in turn stimulates the economy.

Expansionary policy can use both tactics at the same time: increasing government spending while also slashing taxes. This method results in lots of extra money to boost the economy, but in the long run, it also increases the federal debt. In the U.S., the federal debt has ballooned further thanks to the use of expansionary fiscal policy when the economy is already booming. For example, the 2017 Tax Cut and Jobs Act reduced taxes at a time when the economy was doing well (based on economic growth, low unemployment, and consumer confidence). The Congressional Budget Office expected the bill to add $1.9T to the federal deficit within a decade, even accounting for any growth that resulted.

When inflation is spiking and the cost of living is rapidly rising, the government might choose to use contractionary fiscal policy to slow it down. This can involve raising taxes or cutting government spending. Contractionary fiscal policy is a rare occurrence, in part because of how unpopular it is among voters. There is also a risk that it can increase unemployment or result in the economy slowing too much.

The basic principles of fiscal policy can be traced back to John Maynard Keynes, a British economist born in the late 1800s and the founder of Keynesian economics. Keynes believed that consumer demand was the primary factor in economic growth. He supported expansionary fiscal policy as a means to get people to spend more money and argued that government spending was the best way to increase employment.

The U.S. didn’t really begin to implement fiscal policy until the 1930s as a response to the Great Depression. President Franklin D. Roosevelt established a firm expansionary policy in the form of government spending to boost the economy. This included the Works Progress Administration, which employed people to build infrastructure and carry out other projects, and the Social Security Administration, which provided income to retirees and others. These policies helped reduce unemployment and end the Great Depression.

More recently, the U.S. government used expansionary fiscal policy in response to the Great Recession. In 2008, Congress passed the Economic Stimulus Act, which provided taxpayers with rebates — generally $600 — in the hopes they would spend more money. The following year, Congress passed the American Recovery and Reinvestment Act, which invested billions of dollars in infrastructure, energy independence, business development, and other projects in an effort to create and save jobs. Both of these laws were examples of expansionary fiscal policy, using the two different tools at Congress’s disposal.

Fiscal policy and monetary policy are both ways in which the government influences the economy. Ultimately, the two are meant to work together.

Fiscal policy is usually Congress’s job and is carried out through taxation and government spending. Monetary policy, on the other hand, manages the country’s money supply and interest rates. In the U.S., this is the job of the Federal Reserve, the nation’s central bank. The primary goals of monetary policy are to manage inflation, maximize employment, and keep long-term interest rates moderate. The Fed accomplishes these goals by increasing or decreasing interest rates, buying and selling U.S. government bonds, and changing bank reserve requirements.

Similar to fiscal policy, there are two primary types of monetary policy: expansionary and contractionary. Expansionary monetary policy is used to avoid recession, decrease unemployment, and speed up economic growth. Contractionary monetary policy is used to control inflation and slow down economic growth.

Expansionary monetary policy can include increasing the amount of money in circulation (giving banks more money to lend). Or the Fed can lower interest rates in the hopes of encouraging more people to take out loans to invest in businesses and make big-ticket purchases.

Contractionary monetary policy can include decreasing the money supply so that banks have less to lend. The Fed can also increase interest rates, meaning fewer people will take out loans.