Fiscal policy is defined as government spending and taxation, and plays an important role in economic stabilization. Expansionary fiscal policy, such as increased spending and tax cuts, can stimulate a battered economy and return it to a growth trajectory. Contractionary fiscal policy, on the other hand, can check inflationary risk in an overheating economy. Since fiscal policy has direct and measurable effects on employment and consumer income; it straddles both economic and political agendas.
Fiscal Policy Tools
Fiscal policy is broken down into two categories: government spending and taxation. As a spender, the government has the power to create and remunerate public sector jobs, invest in public works like highways and provide transfer payments to the citizenry, such as Social Security benefits. As a taxer, the government has the power to levy taxes on individuals and corporations, effectively raising or lowering their disposable income.
Expansionary Fiscal Policy
Fiscal policy is said to be loose or expansionary when government spending exceeds revenue. In these cases, the fiscal budget is in deficit. While the absolute amount of deficit is important, what is often more important is the change in the deficit (or surplus). Government action to cut taxes, increase transfer payments or both, has the effect of raising households’ disposable incomes and promoting consumer spending.
Contractionary Fiscal Policy
Fiscal policy is said to be tight or contractionary when government revenue exceeds spending. In these cases, the fiscal budget is in surplus. While the absolute amount of surplus is important, what is often more important is the change in the surplus (or deficit). Government action to raise taxes, reduce transfer payments or both, has the effect of reducing households’ disposable incomes and depressing consumer spending.
Impact on the Interest Rates and the Exchange Rate
Fiscal policy has macroeconomic implications beyond consumer spending. In particular, it affects the interest rate and exchange rate. When the government runs a deficit, it must borrow from investors by issuing Treasury bonds. This has the effect of raising the interest rate as the government competes with other borrowers, such as corporations, for consumers' savings. A higher interest rate has the knock on effect of attracting more foreign capital, leading to an appreciation of the dollar.
Limitations of Fiscal Policy
In the long run, the effects of fiscal policy are limited as shifts in aggregate demand manifest themselves in the price level, not in output. Over long periods of time, an economy's output is determined by the supply, not the demand, of factors of production: capital, labor and technology. Fiscal policy can exert a temporary influence on an economy's rate of output, but attempts to manipulate this natural rate of output over the long run are likely to be less and less effective.
References
- Library of Economics and Liberty; The Concise Encyclopedia of Economics; David N. Weil
- SparkNotes: Tax and Fiscal Policy
- Congressional Research Service. "Introduction to U.S. Economy: Fiscal Policy." Accessed Jan. 27, 2020.
- Board of Governors of the Federal Reserve System. "Federal Open Market Committee (FOMC) Projection Materials." Accessed Jan. 27, 2020.
- Congressional Research Service. "Introduction to U.S. Economy: The Business Cycle and Growth." Accessed Jan. 27, 2020.
- Congressional Research Service. "Key Issues in Tax Reform: Dynamic Scoring." Accessed Jan. 27, 2020.
- Gov Spend. "The Difference Between Federal, State and Local Governments’ Budgets." Accessed Jan. 27, 2020.
- Committee for a Responsible Federal Budget. "Q&A: Everything You Should Know About the Debt Ceiling." Accessed Jan. 27, 2020.
- Congressional Research Service. "Fiscal Policy: Economic Effects." Accessed Jan. 27, 2020.
- Federal Reserve Bank of St. Louis Economic Research (FRED). "Federal Debt: Total Public Debt as Percent of Gross Domestic Product." Accessed Jan. 27, 2020.
- Center on Budget and Policy Priorities. "Policy Basics: Where Do Our Federal Tax Dollars Go?" Accessed Jan. 27, 2020.
- Center on Budget and Policy Priorities. "Policy Basics: Introduction to the Federal Budget Process." Accessed Jan. 27, 2020.
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- Congress.gov. "Actions - H.R.1 - American Recovery and Reinvestment Act of 2009." Accessed Jan. 27, 2020.
- United States Congress Joint Economic Committee. "Why the Fed Matters." Accessed Jan. 27, 2020.
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- USA.gov. "Budget of the U.S. Government." Accessed Jan. 27, 2020.
- Congressional Budget Office. "Mandatory Spending in 2018: An Infographic." Accessed Jan. 27, 2020.
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- Roosevelt Institute. "How FDR Learned to Stop Worrying and Love Keynesian Economics." Accessed Jan. 27, 2020.
- Roosevelt Institute. "FDR and the Fed." Accessed Jan. 27, 2020.
- Bureau of Economic Analysis. "National Data: National Income and Product Accounts: Table 1.1.1. Percent Change From Preceding Period in Real Gross Domestic Product." Accessed Jan. 27, 2020.
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Giulio Rocca's background is in investment banking and management consulting, including advising Fortune 500 companies on mergers and acquisitions and corporate strategy. He also founded GradSchoolHeaven.com, an online resource for graduate school applicants. He holds a Bachelor of Science in economics from the University of Pennsylvania, a Master of Arts in English from the University of Hawaii at Manoa, and a Master of Business Administration from Harvard University.