Fiscal Policy

Fiscal policy is the means by which a government adjusts its levels of spending in order to monitor and influence a nation’s economy. Fiscal policy is a vital policy carried out by government. Government targets following macroeconomic variables by adjusting in the level and composition of taxation and government spending.

  • Aggregate demand and level of economic activity.
  • The pattern of resource allocation.
  • The distribution of income.

Thus in general, fiscal policy refers to the use of government budget to influence economic activity.

Before the Great Depression in the United States, the government’s approach to the economy was laissez faire. But following the Second World War, 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.

Fiscal policy is based on the theory of John Maynard Keynes, also known as Keynesian Economics. This theory advocates direct government intervention to economy. It states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending.

Stances of Fiscal Policy

There are three main stances of fiscal policy, which are:

  • Neutral fiscal policy, usually undertaken when economy is in an equilibrium level. Government spending is just covered by tax revenue and has a neutral effect on the level of economic activity.
  • Expansionary fiscal policy involves government spending exceeding tax revenue, and is usually undertaken during recessions.
  • Contractionary fiscal policy occurs when government spending is lower than tax revenue, and is usually undertaken to pay down government debt.

Fiscal policy cannot correct economy alone. There is its sister strategy monetary policy to fine tune the economy in desired level. Through monetary policy a central bank influences a nation’s money supply. These two policies are used in various combinations in an effort to direct a country’s economic goals. By using a mixture of both monetary and fiscal policies, governments are able to control economic phenomena.

Methods of Funding

Government spend money on a wide variety of things, from military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. These expenditures can be funded in a number of different ways:

  • Taxation
  • Borrowing money from citizen or abroad
  • Consumption of fiscal reserves
  • Sale of fixed assets.

Macroeconomic Objectives of Fiscal Policy

  • To achieve desirable price level
  • To achieve desirable employment level
  • To achieve desirable income distribution
  • Increase in capital formation
  • Degree of inflation

One of the biggest obstacles facing policymakers is deciding how much involvement the government should have in the economy. Indeed, there have been various degrees of interference by the government over the years. But for the most part, it is accepted that a degree of government involvement is necessary to sustain a vibrant economy, on which the economic well-being of the population depends.


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