Businesses and individuals benefit when there is strong economic growth, low unemployment and a modest inflation rate. Prior to the Great Depression of the 1930s, economic thinkers believed these goals were best achieved when governments did not meddle in the economy. The economic hardships of the 1930s led to a profound change in this view, and today government plays a key role in promoting economic stability and growth. Fiscal policy is the general term for some of the key strategies used by policymakers to foster sustainable economic growth.
There are two basic components of fiscal policy: government spending and tax rates. Fiscal policy varies in response to changing economic indicators. In general, an expansionary approach is used when the economy slows down or enters a recession and unemployment rises. Under these conditions, policymakers try to stimulate economic activity by increasing spending, cutting taxes or by doing both. These strategies put more money into the hands of consumers and businesses.
However, the economy can become "overheated," so to speak. When there is high employment and strong consumer demand, prices tend to rise and the rate of inflation can jump. When this happens, policymakers may reverse expansionary fiscal policies and curtail spending or raise taxes. The goal is to achieve a balance that fosters sustainable economic growth and a strong job market without excessive inflation or large deficits.
One of the tools used in fiscal policy is spending that is designed to stimulate the economy. This is often accomplished through public funding of useful projects such as improvements in infrastructure. Suppose policymakers decide to fund a major road building project. Construction companies get contracts and hire workers. The workers spend their wages, thereby increasing consumer demand and stimulating other businesses. Spending initiatives have often been effective in spurring economic growth, but they can have a long-term downside. Too much consumer demand can boost the rate of inflation. In addition, the government may create deficits by borrowing the money it spends, adding to the public debt in the process.
Politicians love to promise tax cuts and may have a good reason for doing so. A tax cut can put more money into people's pockets. The result is increased consumer demand that stimulates economic activity. Tax cuts to business such as those provided in the Tax Cuts and Jobs Act of 2017 let businesses keep more profit. The idea here is to incentivize businesses to invest and hire more workers. As with spending, there is a potential downside. When the government cuts taxes, it also cuts its revenues. This can lead to deficits which will eventually have to be offset by tax increases if economic growth does not generate enough new tax revenue.
The instruments of fiscal policy are not the only tools policymakers use to promote healthy economic conditions. Monetary policy also plays a key role. In the United States, fiscal policy is carried out by the executive and legislative branches of government. An independent government agency, the Federal Reserve Board, sets monetary policy. Essentially, the idea is to influence the money supply and to foster economic growth and manage inflation by managing the money supply.
The Fed, as it's commonly called, does this in three ways. They may buy and sell government debt, thereby adding to or reducing the money supply. An increase in the amount of money in circulation stimulates the economy. A decrease helps to reduce inflation. The Fed can also increase or lower the amount of reserves banks must have on hand. This affects how much money banks have available to lend. Finally, the Fed can raise or lower the federal discount rate. Major banks follow suit. By raising or lowering interest rates, the Federal Reserve Board can influence the cost of private borrowing and thus how much individuals and businesses can borrow and spend.