Fiscal policy is the means by which a government adjusts its spending levels and tax rates to

monitor and influence a nation's economy. It is the sister strategy to monetary policy through
which a central bank influences a nation's money supply. These two policies are used in various
combinations to direct a country's economic goals. Here we look at how fiscal policy works, how
it must be monitored and how its implementation may affect different people in an economy.
Before the Great Depression, which lasted from Sept. 4, 1929 to the late 1930s or early 1940s,
the government's approach to the economy was laissez-faire. Following World War II, it was
determined that the government had to take a proactive role in the economy to regulate
unemployment, business cycles, inflation and the cost of money. By using a mix of monetary
and fiscal policies (depending on the political orientations and the philosophies of those in
power at a particular time, one policy may dominate over another), governments are able to
control economic phenomena.
How Fiscal Policy Works
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known
as Keynesian economics, this theory basically states that governments can influence
macroeconomic productivity levels by increasing or decreasing tax levels and public spending.
This influence, in turn, curbs inflation (generally considered to be healthy when between 2-3%),
increases employment and maintains a healthy value of money. Fiscal policy is very important
to the economy. For example, in 2012 many worried that the fiscal cliff, a simultaneous increase
in tax rates and cuts in government spending set to occur in January 2013, would send the U.S.
economy back to recession. The U.S. Congress avoided this problem by passing theAmerican
Taxpayer Relief Act of 2012 on Jan. 1, 2013. Quantitative Easing is also a type of fiscal policy,
implemented in Europe in several iterations in response to the eurozone debt crisis.
TOOLS Government Spending
Government spending includes the purchase of goods and services - for example, a fleet of new
cars for government employees or missiles for national defense. Government spending is a
fiscal policy tool because it has the power to raise or lower real GDP. By adjusting government
spending, the government can influence economic output.
In addition to the primary effect of government spending on the economy, this spending
multiplies through the economy as it affects businesses who sell the goods and services bought
by the government. Consumers then go on to spend the paychecks they earn from those
businesses, stimulating real GDP even more.
For example, when Larry's Limos receives a large order for more government vehicles, his sales
increase, and he hires more employees who earn a paycheck from the company. Once they
cash their paycheck, they spend this money on goods and services, and the effect of a single
increase in government spending now leads to a much greater result - an effect that economists
call the multiplier effect.
Taxes
Alright, let's talk about taxes. Taxes are a fiscal policy tool because changes in taxes affect the
average consumer's income, and changes in consumption lead to changes in real GDP. So, by
adjusting taxes, the government can influence economic output. Taxes can be changed in
several ways. Firstly, marginal tax rates can be raised or lowered. Secondly, they can be
eliminated entirely, or the tax rules can be modified.
Transfer Payments
Alright. We've talked about government spending, then we talked about taxes - now let's talk
about transfer payments. Transfer payments include things like Social Security, welfare or
unemployment checks. These checks go out all over the country on a monthly basis and serve
as the income for tens of millions of consumers. Transfer payments are fiscal policy tools in the
same way that taxes are because changes in transfer payments lead to changes in consumer
income, and when consumers spend more of their income, this influences economic output.
Tools of Fiscal Policy
The first tool is taxation. That includes income, capital gains from investments, property, sales,
or just about anything else. Taxes provide the major revenue source that funds the government.

The downside of taxes is that whatever or whoever is taxed has less income to spend
themselves. That makes taxes unpopular. Find out exactly how the U.S. Federal budget is
funded in Federal Income and Taxes.
The second tool is government spending. That includes subsidies, transfer payments
including welfare programs, public works projects, and government salaries. Whoever receives
the funds has more money to spend. That increases demand and economic growth.
The Federal government is losing its ability to use discretionary fiscal policy. Each year, more of
the budget must go to mandated programs. As the population ages, the costs of Medicare,
Medicaid, and Social Security are rising. Changing mandatory fiscal policy requires an Act of
Congress, and that takes a long time. One exception was the ARRA, or Economic Stimulus Act,
which Congress passed quickly. That's because legislators knew they must stop the
worst recession since the Great Depression.
Taxes influence the economy by determining how much money the government has to spend in
certain areas and how much money individuals have to spend. For example, if the government
is trying to spur spending among consumers, it can decrease taxes. A cut in taxes provides
families with extra money, which the government hopes they will turn around and spend on
other goods and services, thus spurring the economy as a whole
Spending is used as a tool for fiscal policy to drive government money to certain sectors that
need an economic boost. Whoever receives those dollars will have extra money to spend and,
as with taxes, the government hopes that money will be spent on other goods and services. The
key is finding the right balance and making sure the economy doesn't lean too far either way.
Prior to the Great Depression in the 1920s, the U.S. government took a very hands-off approach
when it came to setting economic policy. Afterward, the U.S. government decided it needed to
play a larger role in determining the direction of the economy.
Types of fiscal policy
There are two main types of fiscal policy: expansionary and contractionary. Expansionary fiscal
policy, designed to stimulate the economy, is most often used during a recession, times of high
unemployment or other low periods of the business cycle. It entails the government spending
more money, lowering taxes, or both. The goal is to put more money in the hands of consumers
so they spend more and stimulate the economy.
Contractionary fiscal policy is used to slow down economic growth, such as when inflation is
growing too rapidly. The opposite of expansionary fiscal policy, contractionary fiscal policy raises
taxes and cuts spending.
Setting fiscal policy
Today's U.S. fiscal policies are tied into each year's federal budget. The federal budget spells
out the governments spending plans for the fiscal year and how it plans to pay for that
spending, such as through new or existing taxes. The budget is developed through a
collaborative effort between the president and Congress.
The president will first submit a budget to Congress that sets the tone for the coming year's
fiscal policy by outlining how much money the government should spend on public needs, such
as defense and health care; how much the government should take in in tax revenues; and how
much of a deficit, or surplus, is projected. Congress then reviews the president's budget request
and develops its own budget resolutions, which set broad levels for spending and taxation.
Once those are approved, legislators start the appropriations process, which spells out where
each dollar will be spent. The president must sign those appropriations bills before they can be
enacted.
Components of Fiscal Policy There are four key components of Fiscal Policy are as follows:
Taxation Policy Expenditure Policy Investment & Disinvestment policy Debt / surplus
management. Taxation Policy We have already discussed in detail about the taxation policy in
previous module. The government gets revenue from direct and indirect taxes. Via its fiscal
policy, government aims to keep the taxes as much progressive as possible. Further, judicious
taxation decisions are very important for economy because of two reasons: Higher than usual
tax rate will reduce the purchasing power of people and will lead to an decrease in investment
and production. Lower than usual tax rates would leave more money with people to spend and
this would lead to inflation. Thus, the government has to make a balance and impose correct tax
rate for the economy. Expenditure Policy Expenditure policy of the government deals with

revenue and capital expenditures. These expenditures are done on areas of development like
education, health, infrastructure etc. and to pay internal and external debt and interest on those
debts. Government budget is the most important instrument embodying expenditure policy of
the government. The budget is also used for deficit financing i.e. filling the gap between
Government spending and income. Investment and Disinvestment Policy Optimum levels of
domestic as well as foreign investment are needed to maintain the economic growth. In recent
years, the importance of FDI has increased dramatically and has become an instrument of
integrating the domestic economies with global economy. Debt / Surplus Management If the
government received more than it spends, it is called surplus. If government spends more than
income, then it is called deficit. To fund the deficit, the government has to borrow from domestic
or foreign sources. It can also print money for deficit financing.
Effects of Fiscal Policy
The objectives of fiscal policy vary with duration and economy of application. In the short term,
governments may focus on macroeconomic stabilization with aims of stimulating an ailing
economy, combating rising inflation, or helping reduce external vulnerabilities. In the longer
term, the aim may be to foster sustainable growth or reduce poverty with actions on the supply
side to improve infrastructure or education. Although these objectives are common among
countries, their relative importance differs depending on the country circumstances. In the short
term, priorities may reflect the business cycle or response to a natural disaster while in the
longer term; the catalysts can be development levels, demographics, or resource endowments.
The macroeconomic effects of fiscal policy have to be studied under two circumstances: one
with reduced expenditure (less spending) and the other with reduced revenue (less taxes). The
results of lessened expenditure have, in general, a small effect on GDP; and they dont impact
private consumption significantly. Although they do have a negative effect on private investment,
a varied effect on housing prices, lead to a quick fall in stock prices and depreciation of the real
effective exchange rate.
Reduced taxes have the inverse outcomes as they have positive (although lagged) effects on
GDP and private investment; have a positive effect on both housing and stock prices; and lead
to appreciation of the real effective exchange rate.

Big deficits and rising public debt

Fiscal deficits and public debt ratios (the ratio of debt to GDP) have expanded sharply in many
countries because of the effects of the crisis on GDP and tax revenues as well as the cost of the
fiscal response to the crisis. Support and guarantees to financial and industrial sectors have
added to concerns about the financial health of governments. Many countries can afford to run
moderate fiscal deficits for extended periods, with domestic and international financial markets
and international and bilateral partners convinced of their ability to meet present and future
obligations. Deficits that grow too large and linger too long may, however, undermine that
confidence. Aware of these risks in the present crisis, the IMF in late 2008 and early 2009 called
on governments to establish a four-pronged fiscal policy strategy to help ensure solvency:
stimulus should not have permanent effects on deficits; medium-term frameworks should
include commitment to fiscal correction once conditions improve; structural reforms should be
identified and implemented to enhance growth; and countries facing medium- and long-term
demographic pressures should firmly commit to clear strategies for health care and pension
reform. Even as the worse effects of the crisis recede, fiscal challenges remain significant,
particularly in advanced economies in Europe and North America and this strategy remains as
valid as ever.