posted on 10-01-2019

Fiscal Policy

Updated October 2, 2019

What Is Fiscal Policy?

Fiscal policy refers to a government's spending and taxation policies intended to maintain economic stability, which is indicated by levels of unemployment, interest rates, prices and economic growth.

How Fiscal Policy Works

A government is capable of directly affecting economic activity in response to fluctuations in macroeconomic growth. Via two key tools at its disposal -- taxation and public spending -- a government can control price inflation, unemployment rates, and interest rate levels.

Fiscal policy is used to slightly adjust the economy in different ways through two kinds of fiscal policies. Expansionary fiscal policy (the most common method employed) attempts to enhance economic growth through taxes and spending, while contractionary fiscal policy is designed to slow economic growth to cutback inflation.

Why Fiscal Policy Matters

In short, fiscal policy is an essential tool for a government to provide peace and prosperity for its citizens. As the administrative body responsible for public wellbeing, a government implements fiscal policy in an effort to defend the interests of businesses and consumers from economic forces which, if left unchecked, could have adverse consequences.

The important goals of a government's fiscal policy include maintaining full employment, generating a high cycle of economic growth, and keeping prices and wages stable. Fiscal policy is also used to slow inflation, amplify aggregate demand and factor in to other macroeconomic issues. 

Fiscal Policy Example

In an example of fiscal policy, in order to curb price inflation, which is associated with high levels of consumer spending, a government may institute higher taxes resulting in lower levels of disposable income. Likewise, a government might engage in public spending in order to increase an economy's cash flow during times of recession.

Fiscal Policy vs. Monetary Policy

While fiscal policy is carried out through government spending and taxation, monetary policy is the means by which the Federal Reserve manipulates the U.S. money supply in order to influence the national economy's overall direction. This is particularly aimed at the areas of employment, production, and prices.

When it comes to monetary policy, many economists agree that the Federal Reserve is the most important political tool a government has; this is because each of a monetary policy's actions influence the everyday financial decisions of the citizens of the economy: Whether they should buy a car, save more money, or start a business.