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What Is the Relationship between Fiscal Policy and Inflation?

Esther Ejim
Esther Ejim

The relationship between fiscal policy and inflation is the fact that fiscal policy is a macroeconomic tool that is utilized by the government to influence the level of economic activity in a country. Such fiscal policies are applied to achieve a desired effect in the economy after an analysis of the economic trends in the economy under consideration. If the analysis reveals undesirable economic trends like inflation, the government could use fiscal policy as one of the methods for reversing the trend or bringing it under control.

Two main vehicles for the transference of fiscal policy in the economy are the patterns of aggregate spending by the government and adjustments in taxation levels or patterns. Fiscal policy and inflation are related in this sense by the effect that the adjustments made by the government to these two factors has on inflation levels. Governments usually carry out a constant assessment of the economy through the study of the result of periodic business cycles. When it observes the fact that the level of inflation is increasing beyond desirable levels, it will apply the fiscal policies as a means of controlling the underlying factors of demand and consumption that fuel such inflationary trends.

As a form of monetary policy, nations will at times intentionally aim to increase inflation, which decreases the value of its currency.
As a form of monetary policy, nations will at times intentionally aim to increase inflation, which decreases the value of its currency.

Fiscal policy and inflation connections can be seen in the manner in which various adjustments to the taxation scheme influences the level of inflation in the economy. Assuming the government decides to increase the level of income tax, this type of policy will have a wider effect that will affect inflation levels. Such an increase in the taxation of personal income will lead to a corresponding decrease in the total disposable or spendable income of consumers. The assumption is that when consumers do not have as much money to spend after the calculation of their net pay, they will make a downward reversal in their spending and consumption habits, reducing the aggregate demand in the economy, and also bringing down the level of inflation.

The Federal Reserve constantly monitors for inflationary risks to the U.S. economy, and may respond with actions or policies to try to stave off price increases.
The Federal Reserve constantly monitors for inflationary risks to the U.S. economy, and may respond with actions or policies to try to stave off price increases.

Another connection between fiscal policy and inflation can be seen in the effect that a contractionary fiscal policy has on the economy. When the government observes unwanted inflationary trends, it can arrest or reduce such a trend by reducing its expenditure in relation to its tax revenue for the year. In such a situation, the government limits its rate of spending. Such a practice will serve to reduce the level of economic activity, causing a reduction in the amount of money in the economy and reducing the level of inflation.

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Discussion Comments

SteamLouis

The goal with most fiscal policies is to keep inflation at the target rate. So almost all the time, the government is trying to increase inflation or decrease it. Actually we should be talking about the relationship between aggregate demand (AD) and inflation. Because fiscal policies usually control inflation by causing changes in AD. It's either done by automatic fiscal policies or discretionary fiscal policies.

discographer

@turquoise-- I'll try to answer that for you.

What you said is right. It's not good for inflation to be very low or high. If inflation is very low, then the government will use a contractionary fiscal policy to slow down the economy. So the government will reduce government spending or increase taxes. Both of these will reduce the amount of money in the market and people will have less money to spend. This will reduce inflation.

Inflation is a sign of a growing economy. It means that people are spending a lot of money. But this is troublesome because eventually supply will not be able to keep up with demand. By lowering demand, the problem can be prevented.

turquoise

I recently learned that low or no inflation (deflation) is just as bad as high inflation. I used to think that low inflation is good, but apparently that's not the case. Economist don't want inflation to be too high or too low.

So what type of fiscal policy will a government use when inflation is too low?

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    • As a form of monetary policy, nations will at times intentionally aim to increase inflation, which decreases the value of its currency.
      By: Vasiliy Koval
      As a form of monetary policy, nations will at times intentionally aim to increase inflation, which decreases the value of its currency.
    • The Federal Reserve constantly monitors for inflationary risks to the U.S. economy, and may respond with actions or policies to try to stave off price increases.
      By: qingwa
      The Federal Reserve constantly monitors for inflationary risks to the U.S. economy, and may respond with actions or policies to try to stave off price increases.
    • An example of a type of inflation would be the increase in price of postage stamps, which in the U.S. went up to 25 cents in 1988 and nearly doubled in price within 27 years.
      By: Blue Moon
      An example of a type of inflation would be the increase in price of postage stamps, which in the U.S. went up to 25 cents in 1988 and nearly doubled in price within 27 years.