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What Is Fiscal Policy?

Chime Team • July 11, 2024

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Fiscal Policy

Fiscal policy is essentially the government’s game plan for managing its budget to influence economic conditions, like growth rates, employment, and inflation.¹ It involves adjusting government spending and tax policies to better control the economy. Depending on what the economy needs, fiscal policy can either stimulate (“boost”) or slow down (“cool down”) economic activity.

Understanding fiscal policy helps people see how government actions affect the economy’s overall health, impacting employment rates, consumer spending, and borrowing costs. For example, a government might use a common strategy known as expansionary fiscal policy.² This is when the government reduces taxes or increases public spending to stimulate economic growth, potentially leading to higher employment rates and increased household disposable income.

Perhaps the most notable example of expansionary fiscal policy is the American Recovery and Reinvestment Act of 2009. To counteract the Great Recession, the U.S. government injected funds into the economy through infrastructure projects, tax cuts, and direct transfers.³ On the other hand, a government might reduce spending and increase taxes to control inflation or cool an overheated economy, which is known as contractionary fiscal policy.

The principles guiding U.S. fiscal policy are inspired by the work of John Maynard Keynes, a British economist who lived from 1883 to 1946. Keynes believed that economic downturns result from insufficient consumer spending and lack of business investment.

He advocated for government intervention to stabilize economic fluctuations and manage economic output. He believed that by modifying government spending and tax policies, the government could offset the deficiencies in private-sector demand. His ideas were formed in the wake of the Great Depression, challenging the classical economic view that markets would automatically correct themselves.

How does fiscal policy work?

Fiscal policy works by influencing economic demand. When the government spends more, it can boost demand by creating jobs and increasing income. Tax cuts can leave businesses and consumers with more disposable income, leading to more spending and investment. Conversely, raising taxes and cutting government spending can help slow down an overheated economy by reducing demand.

For example, when a government invests heavily in its infrastructure, it creates jobs and improves public assets like roads and schools, which can enhance long-term economic productivity. Increased government spending can directly contribute to higher gross domestic product (GDP) growth rates, showing a clear connection between fiscal policy and economic health.

Fiscal policy can impact various sectors – like construction, healthcare, and education – through government spending in these areas. For example, more spending on healthcare can lead to better public health outcomes, which can improve workforce productivity. Investing in education can build a more skilled workforce, driving innovation and economic growth in the long term.

Fiscal policy vs. monetary policy

Fiscal policy is closely linked to monetary policy, another economic management tool central banks use to control money supply and interest rates. While fiscal policy deals with government budgeting, monetary policy focuses on banking and financial conditions to achieve similar economic objectives. For instance, while the Federal Reserve might lower interest rates to encourage borrowing and investment, the government could simultaneously increase spending to achieve a similar stimulative effect.

Fiscally minded financial planning

Fiscal policy is a crucial element in managing economic stability and growth. It demonstrates the government’s influence on economic conditions through spending and taxation.

Understanding fiscal policy can help us make more informed decisions about our personal finances. For example, knowing about potential tax changes can influence decisions about investments, savings, and major purchases. Anticipating when the government might implement expansionary fiscal policies can help us plan for economic upswings or prepare for downturns during contractionary phases.

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1 Information from Econlib’s “Fiscal Policy” as of June 28, 2024: https://www.econlib.org/library/Enc/FiscalPolicy.html 

2 Information from Corporate Finance Institute’s “Expansionary Policy” as of July 1, 2024: https://corporatefinanceinstitute.com/resources/economics/expansionary-policy/

3 Information from Congress’ “American Recovery and Reinvestment Act of 2009 as of June 28, 2024: https://www.congress.gov/bill/111th-congress/house-bill/1/text 

4 Information from Congressional Research Service’s “Introduction to U.S. Economy: Fiscal Policy” as of June 28, 2024: https://sgp.fas.org/crs/misc/IF11253.pdf 

5 Information from International Monetary Fund’s “Back to Basics: What Is Keynesian Economics?” as of June 28, 2024: https://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm

6 Information from International Monetary Fund’s “What is Keynesian Economics?” as of June 28, 2024: https://www.imf.org/external/pubs/ft/fandd/basics/pdf/jahan_keynes.pdf 

7 Information from U.S. Department of the Treasury Fiscal Data’s “What is the national deficit?” as of June 28, 2024: https://fiscaldata.treasury.gov/americas-finance-guide/national-deficit/ 

8 Information from the Federal Reserve’s “FAQs: What is the difference between monetary policy and fiscal policy, and how are they related?” as of June 28, 2024: https://www.federalreserve.gov/faqs/money_12855.htm

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