Instruments of Fiscal Policy

by Christopher Raines; Updated September 26, 2017

Fiscal policy refers to the measures by which lawmakers try to manipulate the production of and demand for goods and services by individuals, businesses and governments. After the Great Depression of the 1930s, policymakers and economists eschewed the hands-off approach to the marketplace in favor of heightened government intervention. The instruments of fiscal policy serve goals of stimulating economic prosperity and growth, reducing poverty and destitution and chipping away at income inequality.

Spending

Governments often loosen the public purse strings to revive sluggish economies. During the Great Depression, Congress created national parks such as the Blue Ridge Parkway in North Carolina and Virginia and projects such as the Tennessee Valley Authority to put people to work and spur economic activity. As reported by the Federal Reserve Bank of St. Louis, the 2009 stimulus included $150 billion in spending for education, energy and transportation. The spending, though, might not catch up with the economy because of the time spent approving the government's budget -- a year to 18 months -- and planning specific projects. More spending can also raise prices and lead to inflation.

A Taxing Approach

In 1981 and 1982, the U.S. government cut taxes to stimulate the economy. Policy makers rely on lower taxes to put more money in consumers' and businesses' pockets and drive demand upward in flailing economies, says the International Monetary Fund. Lowering taxes, though, usually yields a gradual rather than immediate economic benefit because part of the tax reduction is saved rather than spent. When inflation threatens, according to the IMF, expect tax increases to curb private spending.

Redistribution of Income

When the government pays out Social Security, unemployment and welfare benefits, it expects nothing such as a product or service in return. As suggested by the International Monetary Fund's staff note Income Inequality and Fiscal Policy, the government employs these and other forms of income redistribution to do more than grow the gross national product. According to the IMF report, income transfers are tools for reducing the gap between rich and poor and removing barriers to health care and political and other resources. Social Security, which began in 1935 during the Great Depression, was created as a safety net to protect retired workers against swings -- especially downward ones -- in the economy.

Automatic Adjustment

The ebbs and flows of business -- the business cycle -- can influence economic activity, independent of specific government actions. As the IMF explains, tax collections decline when production declines and business and individual incomes dwindle. In lean times, government will spend more on unemployment benefits and other welfare programs because the numbers of eligible recipients will rise. During expansion of the economy, the public's need for income assistance will decline and spending on this assistance will go down as well. According to the IMF, these automatic stabilizers hold more sway in larger economies.

About the Author

Christopher Raines enjoys sharing his knowledge of business, financial matters and the law. He earned his business administration and law degrees from the University of North Carolina at Chapel Hill. As a lawyer since August 1996, Raines has handled cases involving business, consumer and other areas of the law.