Fiscal policy is the use of government spending and taxes to influence the country’s economy. Governments typically strive to use their fiscal policy in ways that promote strong, sustainable growth and reduce poverty. Fiscal policy definition economics
Main advantages: Tax Policy
- Fiscal policy is how governments use taxation and spending to influence a country’s economy.
- Fiscal policy works alongside monetary policy, which deals with interest rates and the money supply in circulation, and is usually managed by a central bank.
- During recessions, the government may apply expansionary fiscal policy, reducing tax rates to increase aggregate demand and stimulate economic growth.
- Threatened by rising inflation and other perils of expansionary policy, the government may pursue a contractionary fiscal policy.
History and Definition
Fiscal policy is used to influence “macroeconomic” variables – inflation, consumer prices, economic growth, national income, Fiscal policy definition economics
Gross Domestic Product (GDP) and unemployment. In the United States, the importance of these uses of government revenue and spending developed in response to the Great Depression, when the laissez-faire, or “leave it as is,” approach to government economic control adopted by Adam Smith became unpopular. . More recently, the role of fiscal policy came to prominence during the global economic crisis of 2007-2009, when governments intervened to support financial systems, stimulate economic growth, and offset the impact of the crisis on vulnerable groups.
Modern fiscal policy is largely based on the theories of British economist John Maynard Keynes, whose liberal Keynesian economics correctly theorized that government management of changes in taxation and spending influences supply and demand and the general level of economic activity. Keynes’ ideas led to US President Franklin D. Roosevelt’s depression era New Deal programs involving massive government spending on public works projects and social welfare programs.
Governments try to design and apply their fiscal policy in a way that stabilizes the country’s economy throughout the annual business cycle. In the United States, responsibility for fiscal policy is shared by the executive and legislative branches. In the Executive Branch, the position most responsible for fiscal policy is the President of the United States along with the Cabinet-level Secretary of the Treasury and a presidentially appointed Council of Economic Advisers. In the Legislative Branch, the United States Congress, using its constitutionally granted “Bolsa Power” authorizes taxes and passes laws that allocate resources to fiscal policy measures. In Congress, this process requires participation, debate, and approval from both the House of Representatives and the Senate. Fiscal policy definition of economics
Tax Policy vs. Monetary policy
In contrast to fiscal policy, which deals with taxes and government spending levels and is managed by a government department, monetary policy deals with the country’s money supply and interest rates and is often managed by the central bank of the country. authority country. In the United States, for example, while fiscal policy is managed by the President and Congress, monetary policy is managed by the Federal Reserve, which plays no role in fiscal policy.
Governments use a combination of fiscal and monetary policy to control the country’s economy. To stimulate the economy, the government’s fiscal policy will cut tax rates and increase its spending. To slow down a “runaway” economy, it will raise taxes and reduce spending. If it is necessary to stimulate a shrinking economy, the central bank will alter its monetary policy, often lowering interest rates, thereby increasing the money supply and making it easier for consumers and businesses to borrow. If the economy is growing too fast, the central bank will raise interest rates, thus taking money out of circulation. The fiscal policy definition of economics
In the United States, Congress has established maximum employment and price stability as the main macroeconomic objectives of the Federal Reserve. Otherwise, Congress determined that monetary policy should be free from the influence of policy. As a result, the Federal Reserve is an independent agency of the federal government.
expansion and contraction
Ideally, fiscal and monetary policies work together to create an economic environment in which growth remains positive and stable, while inflation remains low and stable. Fiscal planners and government policymakers strive for an economy free from economic booms that are followed by long periods of recession and high unemployment. In a stable economy, consumers feel secure in their purchasing and saving decisions. At the same time, corporations feel free to invest and grow, creating new jobs and rewarding their bondholders with regular premiums.
In the real world, however, the rise and fall of economic growth is neither random nor inexplicable. The US economy, for example, naturally goes through regularly repeated phases of business cycles highlighted by booms and busts. Fiscal policy definition of economics
During periods of expansion, real gross domestic product (GDP) grows for two or more consecutive quarters as the underlying economy moves from “valleys” to “peaks”. Usually accompanied by rising employment, consumer confidence and the stock market, expansion is considered a period of economic growth and recovery.
Expansions usually occur when the economy is coming out of a recession. To encourage growth, the central bank — the Federal Reserve in the United States — lowers interest rates and adds money to the financial system by buying Treasury bonds on the open market. This replaces bonds held in private portfolios with cash that investors put in banks eager to lend that extra cash. Companies take advantage of the availability of low-interest loans from banks to buy or expand factories and equipment and to hire employees so they can produce more products and services. As GDP and income per capita grow, unemployment goes down, consumers start to spend, and stock markets perform well.
According to the National Bureau of Economic Research (NBER), expansions last about 5 years but can last up to 10 years. Fiscal policy definition of economics
Expansionary economic policy is popular, making it politically difficult to reverse. Even though expansionary policy usually increases the country’s budget deficit, voters like low taxes and public spending. Proving the truth of the old saying that “all good things must come to an end”, expansion can get out of control. The flow of cheap money and increased spending causes inflation to rise. High inflation and the risk of widespread loan defaults can severely damage the economy, often to the point of a recession. To cool the economy and prevent hyperinflation, the central bank raises interest rates. Consumers are encouraged to cut spending to slow economic growth. As corporate profits fall, stock prices fall and the economy enters a period of contraction.
Typically considered a recession, a contraction is a period during which the economy as a whole is in decline. Contractions usually occur after an expansion has reached its “peak”. According to economists, when a country’s GDP has fallen for two or more consecutive quarters, the contraction has become a recession. As the central bank raises interest rates, the money supply shrinks and businesses and consumers cut back on borrowing and spending. Instead of using their profits to grow, rent, and increase production, companies add them to the money they accumulated during the expansion and use it for research and development, and other steps in anticipation of the next expansion stage. When the central bank determines that the economy has “cooled off” the Fiscal policy definition of economics
For most people, an economic downturn brings some degree of financial hardship as unemployment rises. The longest and most painful period of contraction in modern American history was the Great Depression, from 1929 to 1933. The recession of the early 1990s also lasted eight months, from July 1990 to March 1991. The 1980s lasted 16 months, from July 1981 to November 1982. The Great Recession of 2007 to 2009 was 18 months of substantial contraction spurred by the collapse of the housing market – fueled by low-interest rates, easy credit, and insufficient regulation of subprime loan mortgages.