How Does Fiscal Policy Work?

by Giulio Rocca; Updated September 26, 2017

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.

About the Author

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, 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.