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In economics and political science, fiscal policy is the use of government revenue collection ( or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables developed in reaction to the Great Depression of the 1930s, when the previous laissez-faire approach to economic management became unworkable. Fiscal policy is based on the theories of the British economist John Maynard Keynes, whose Keynesian economics theorised that government changes in the levels of taxation and government spending influence aggregate demand and the level of economic activity. Fiscal and monetary policy are the key strategies used by a country's government and central bank to advance its economic objectives. The combination of these policies enables these authorities to target inflation and to increase employment. In modern economies, inflation is conventionally considered "healthy" in the range of 2%–3%. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%. This implies that fiscal policy is used to stabilise the economy over the course of the business cycle. (2025). 9780130630858, Pearson Prentice Hall. ISBN 9780130630858
Changes in the level and composition of taxation and government spending can affect macroeconomic variables, including:
Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by a government department; while monetary policy deals with the money supply, and is often administered by a country's central bank. Both fiscal and monetary policies influence a country's economic performance.
The recession of the 2000s decade shows that monetary policy also has certain limitations. A liquidity trap occurs when interest rate cuts are insufficient as a demand booster as banks do not want to lend and the consumers are reluctant to increase spending due to negative expectations for the economy. Government spending is responsible for creating the demand in the economy and can provide a kick-start to get the economy out of the recession. When a deep recession takes place, it is not sufficient to rely just on monetary policy to restore the economic equilibrium. Each side of these two policies has its differences, therefore, combining aspects of both policies to deal with economic problems has become a solution that is now used by the US. These policies have limited effects; however, fiscal policy seems to have a greater effect over the long-run period, while monetary policy tends to have a short-run success.
In 2000, a survey of 298 members of the American Economic Association (AEA) found that while 84 percent generally agreed with the statement "Fiscal policy has a significant stimulative impact on a less than Full employment economy", 71 percent also generally agreed with the statement "Management of the business cycle should be left to the Federal Reserve; activist fiscal policy should be avoided." In 2011, a follow-up survey of 568 AEA members found that the previous consensus about the latter proposition had dissolved and was by then roughly evenly disputed.
However, these definitions can be misleading because, even with no changes in spending or tax laws at all, Business cycle cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral and effective fiscal policy stance.
The Keynesian view of economics suggests that increasing government spending and decreasing the rate of taxes are the best ways to have an influence on aggregate demand, stimulate it, while decreasing spending and increasing taxes after the economic expansion has already taken place. Additionally, Keynesians argue that expansionary fiscal policy should be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the expansion that would follow; this was the reasoning behind the New Deal. The IS-LM model is another way of understanding the effects of fiscal expansion. As the government increases spending, there will be a shift in the IS curve up and to the right. In the Short-run, this increases the real interest rate, which then reduces private investment and increases aggregate demand, placing upward pressure on supply. To meet the short-run increase in aggregate demand, firms increase Full employment output. The increase in short-run reduces the money supply, which shifts the LM curve back, and thus, returning the general equilibrium to the original full employment (FE) level. Therefore, the IS-LM model shows that there will be an overall increase in the price level and real interest rates in the long run due to fiscal expansion.
Governments can use a budget surplus to do two things:
But still debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out: whether government borrowing leads to higher that may offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or Monetizing debt the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This decreases aggregate demand for goods and services, either partially or entirely offsetting the direct expansionary impact of the deficit spending, thus diminishing or eliminating the achievement of the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective, especially in a liquidity trap where, they argue, crowding out is minimal.
In the classical view, expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand, in turn, causes the currency to appreciate, reducing the cost of imports and making exports from that country more expensive to foreigners. Consequently, decrease and increase, reducing demand from .
Some economists oppose the discretionary use of fiscal stimulus because of the inside lag (the time lag involved in implementing it), which is almost inevitably long because of the substantial legislative effort involved. Further, the outside lag between the time of implementation and the time that most of the effects of the stimulus are felt could mean that the stimulus hits an already-recovering economy and overheats the ensuing h rather than stimulating the economy when it needs it.
Some economists are concerned about potential inflationary effects driven by increased demand engendered by a fiscal stimulus. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been Unemployment, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while Labour supply remains fixed, leading to wage inflation and therefore Price Inflation.
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