What Is Fiscal Policy? How Does Fiscal Policy Affect the Economy?

Brandie E Blackler

Brandie E Blackler

Nov 24, 2022

6 min read

Nov 24, 2022

6 min read

There are many terms in the world of economics, and you may not be familiar with all of them. Fiscal policy may be one of these terms, and you may think it seems important to know. 

Fiscal policy is vital to the operations of any country. Yet, you may have heard the term ‘fiscal policy’ here and there but not have a grasp on what it means.  

Read on to learn about the definition of fiscal policy, what it is, how it affects the economy and more important aspects of fiscal policy and financial markets. 

what is fiscal policy

What Is Fiscal Policy? 

There is no single policy known as ‘fiscal policy.’ Despite its name, fiscal policy is a term that refers to a specific set of changing economic policies. 

In the United States of America, fiscal policy is the use of personal or business tax policies and associated government spending to regulate the economy and related economic conditions. 

Fiscal policy is a set of policies enacted by government officials, such as the President and members of Congress or the Senate. 

One example of fiscal policy is the annual government budget, which is proposed by the President and approved or disapproved by Congress depending on the needs of the country. 

The Origins of Fiscal American Policy 

In America, modern fiscal policy finds its roots in the works of John Maynard Keynes, a 20th-century British economist. 

Keynes is notable for pioneering the theory of macroeconomics and spearheading a Great Depression-era economics movement that saw governments shedding their neoclassical roots. 

In his writings, Keynes indicated that policies enacted by governments could help stabilize economies by increasing or decreasing taxes and the rates of government spending. 

In theory, Keynes believed that the government should make up for deficits in the public sector, providing a stable economy for businesses and citizens. 

Aspects of Fiscal Policies 

As outlined by Keynesian economics, three primary aspects make up the American fiscal policy. These elements are government spending and taxes- particularly taxes on businesses and individuals. 

However, as with all things related to national economics, the mechanisms behind these aspects are more complicated than you might initially estimate. After all, all of these policies must work in tandem to be truly effective. 

Let’s take a closer look into why these tools and policies can affect American economics with such significant efficiency that they can balance injured economies. 

Government Spending and Tools for Expansion 

Government spending is one of the most powerful tools that the government has in its fiscal policy.  

When an economy is in recession, such as the notorious Great Depression in the 1930s that initially spawned Keynesian economics, the government may increase spending to make up for a lack of economic mobility in the private sector. 

A government may choose to undergo more public works projects, such as constructing roads or new buildings.  

By undergoing these projects, a government is fostering economic growth and expansion by creating jobs and increasing economic demand. 

Policy On Business Taxes 

Taxes on businesses may sound similar to taxes on individuals, but in terms of economic policy, they can be entirely different. 

In a recession, a government may choose to lower the taxes it imposes on businesses.  

This tax reduction gives businesses a more significant financial foundation to work with, allowing the company to spend more on marketing, its employees, or contractors. 

By spending further money on its underlings or other ventures, a business can help stimulate the economy and foster economic growth. 

Policy On Individual Taxes 

Let’s return to the recession model once again.  

Tax policies on individuals are one of the most powerful tools to combat a recession. By lowering taxes on individuals, the government gives citizens more money to spend. 

This increase in money for the average citizen helps promote economic growth, as individuals can purchase more items at a higher price.  

When citizens have more money, general demand is increased, requiring companies to hire more employees who will have higher wages and therefore have more money to spend. 

In theory, this is a cycle of constant growth, further fostering economic growth. 

The Difference Between Fiscal and Monetary Policies 

One reason that you may be confused by the fiscal policy is that citizens without economic knowledge may frequently conflate fiscal policy with monetary policy. 

There is one significant difference between fiscal and monetary policies; while elected government officials such as the President enact fiscal policy, organizations such as the Federal Reserve handle monetary policy. 

While fiscal policy helps stabilize the economy and regulate economic conditions, monetary policy seeks to promote employment, regulate the amount of currency in circulation, and regulate interest rates. 

How Does Fiscal Policy Affect the Economy? 

By now, you are aware that fiscal policy is a powerful tool that the government uses to regulate the economy.  

When the government enacts specific policies that concern taxes or government spending, it can greatly affect the economy and economic mobility. 

However, you may not know how they do so. Let’s take a look at the two primary ways that the government affects the economy. 

Lessening The Impact of Recession 

You have seen how fiscal policy can help an economy climb out of recession, but let’s take a deeper look into this phenomenon. 

In economics, a recession is a downturn in economic activity over any region. For example, the American and Worldwide economies may both experience a recession. 

By enacting policies to strengthen the economy, such as lowering taxes on businesses or individuals and increasing government spending without the associated tax increases, the government can allow more money to flow to its citizens. 

When the citizens have more money, the impact of a recession is lessened. 

Slowing Economic Activity 

On the other hand, the government can also use fiscal policy to slow economic activity.  

When an economy achieves unsustainable growth, a government does not want it to crash once it reaches a certain point.  

To prevent inflation and its related crash, the government can enact what it calls ‘contractionary policies.’  

These policies include increasing taxes and reducing spending; these measures reduce economic activity and bring it to a more sustainable level. 

Brandie E Blackler
Brandie E Blackler
Trader and Financial Writer, Admirals, London

Brandie has worked professionally as a financial writer and digital marketing consultant for 12 years, while she also is an active retail swing trader and investor for the past 7 years. Brandie specializes in digital currencies and CFD trading at Admirals

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