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What is Fiscal Policy?

Mary McMahon
Updated Feb 21, 2024
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Fiscal policy is a tool which is used by national governments to influence the direction of the economy, generally with the goal of promoting economic health and growth. Fiscal policies can be approached in a variety of ways, and they tend to vary as heads of state change, because different people have their own approaches to economic issues. Nations must strike a balance with their fiscal policies, so that they benefit the economy without being perceived as too interfering.

The underlying component of fiscal policy is the government's budget, which determines how much it will spend on various goods and services. The amount of the budget is usually tied to tax revenues and other sources of income for the government. In a nation with a neutral fiscal policy, the budget and the tax revenues are equal, while expansionary policies create a budget deficit, because the government is spending more than it takes in. Contractionary or tight policies, by contrast, create a surplus, as tax revenues exceed budget expenditures.

When governments allocate funds to spend on goods and services, they think about the how the market works, and how their activities will impact the economy. For example, the decision to build a road could create a jobs, and stimulate the economies in the communities reached by the road, making the road a justifiable expenditure from the government's perspective. Fiscal policy also includes the establishment of tax policy and tax rates, as governments want to encourage citizens to spend money, thereby increasing demand and promoting economic growth. However, the government must strike a balance, as it needs enough money to function and provide services to citizens.

Citizens are often interested in the fiscal policy of their nations, and the topic commonly comes up during political campaigns. Most citizens would prefer to see tax rates kept low, and government services kept high, which establishes a rather contradictory situation, because the government cannot provide services without revenue. Politicians who claim to be able to accomplish these contradictory goals tend to be very popular.

There is a distinction between fiscal policies and monetary policies. Monetary policy deals specifically with money and the supply of money, revolving around the minting of new money, the establishment of interest rates, and other measures which influence the total supply of a nation's currency. While fiscal and monetary policy are often closely tied, they are separate entities, and in many governments, they are established by different agencies and individuals.

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Mary McMahon
By Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a WiseGEEK researcher and writer. Mary has a liberal arts degree from Goddard College and spends her free time reading, cooking, and exploring the great outdoors.

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Discussion Comments

By cupcake15 — On Feb 11, 2011

SurfNTurf - All I have to say is that I wish President Reagan were back in office.

You know all of the economic periods in which Keynesian economics fiscal policy was followed were the absolute worst periods in economic history.

Those periods were during the Great Depression under FDR, during the stagflation of Jimmy Carter, and during the record high unemployment rates of Obama.

I think that this is proof enough that the only fiscal policy that works is that of reduced government spending and lower taxes.

By surfNturf — On Feb 08, 2011

BrickBack - I agree. The problem is that we have a President that believes in a Keynesian economic fiscal policy model which is backward if you want real recovery. With Keynesian economics you have the massive deficit spending which is supposed to stimulate the economy.

However, businesses are the only ones that can truly stimulate the economy because they are the ones that provide jobs to people and produce products and services that consumers can buy.

Supply side economics which is a totally opposite fiscal policy from Keynesian economics actually allows for real economic growth. Here the government reduces spending and offers tax breaks to all taxpayers and businesses in order to get the economy moving.

The theory is that when businesses pay lower taxes they will expand and hire more workers. Also, when taxes are cut people have more disposable income and will tend to spend more which also stimulates the economy.

This is what happened during President Reagan’s administration. As a result of his fiscal policies, businesses added 25 million jobs and unemployment dropped six percentage points. He also dropped tax rates from 70% under Carter to 24% at the end of his second term.

This is how the right fiscal policy changes unemployment rates.

By BrickBack — On Feb 06, 2011

Bhutan- I have to say that we currently have a contradictory fiscal policy. We talk about growing the economy but growing government spending to catastrophic levels causes a risk of high interest rates and has led to a rise in unemployment rates as well.

When the United States incurs so much debt the only way it can get another country to buy the debt is to offer additional incentives in the form of higher interest rates.

This will be the only way that the US can finance its debt. The incredible thing is how the government continues to spend despite the fact that we are on the verge of losing our AAA bond rating.

This additional government spending through endless regulations has led to the highest unemployment rates since the Great Depression.

By Bhutan — On Feb 05, 2011

I just wanted to add that the difference between monetary and fiscal policy is easy to understand. Monetary policy involves the increase or decrease in the money supply.

For example, recently the US printed over $300 million dollars into our money supply which they referred to as quantitative easing of the money supply.

The theory was that the additional circulation of this money would add to the economic activity. However, the risk of this type of money supply involves inflation. When a currency is debased like this it can result in high levels of inflation which causes us to reduce our buying power on goods and services.

Fiscal policy relates to how the money is infused into the system by way of tax rates, interest rates, and government spending.

Mary McMahon

Mary McMahon

Ever since she began contributing to the site several years ago, Mary has embraced the exciting challenge of being a...

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