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Fiscal policy is the means by which a government adjusts its levels of spending in
order to monitor and influence a nation's economy. It is the sister strategy to monetary policy with
which 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. Here we take a look at how fiscal policy
works, how it must be monitored and how its implementation may affect different people in an
economy. (For background on fiscal policies, see Formulating Monetary Policy.),
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. By using a mixture of both monetary and fiscal policies (depending on the political
orientations and the philosophies of those in power at a particular time, one policy may dominate over
another), governments are able to control economic phenomena.
How Fiscal Policy Works
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known
as Keynesian economics, this theory basically states that governments can
influence macroeconomic productivity levels by increasing or decreasing tax levels and public
spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a level
between 2-3%), increases employment and maintains a healthy value of money. (To read more on
this subject, see ëan Keynesian Economics Reduce Boom-Bust ëycles? and How Influential
Economists ë anged Our History.)
Balancing Act
The idea, however, is to find a balance in exercising these influences. For example, stimulating a
stagnant economy runs the risk of rising inflation. This is because an increase in the supply of money
followed by an increase in consumer demand can result in a decrease in the value of money -
meaning that it will take more money to buy something that has not changed in value.
Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is
down and businesses are not making any money. A government thus decides to fuel the economy's
engine by decreasing taxation, giving consumers more spending money while increasing government
spending in the form of buying services from the market (such as building roads or schools). By
paying for such services, the government creates jobs and wages that are in turn pumped into the
economy. Pumping money into the economy is also known as "pump priming". In the meantime,
overall unemployment levels will fall. (To learn more about inflation and employement, see °urveying
T e Employment Report and T e Importance Of Inflation And GDP.)
With more money in the economy and less taxes to pay, consumer demand for goods and services
increases. This in turn rekindles businesses and turns the cycle around from stagnant to active.
If, however, there are no reins on this process, the increase in economic productivity can cross over a
very fine line and lead to too much money in the market. This excess in supply decreases the value of
money, while pushing up prices (because of the increase in demand for consumer products). Hence,
inflation occurs.
For this reason, fine tuning the economy through fiscal policy alone can be a difficult, if not improbable,
means to reach economic goals. If not closely monitored, the line between an economy that is
productive and one that is infected by inflation can be easily blurred. (For more on economic cycles,
see Understanding ëycles - T e Key To Market Timing and How Muc Influence Does T e Fed
Have?)
And When The Economy Needs To Be Curbed«
When inflation is too strong, the economy may need a slow down. In such a situation, a government
can use fiscal policy to increase taxes in order to suck money out of the economy. Fiscal policy could
also dictate a decrease in government spending and thereby decrease the money in circulation. Of
course, the possible negative effects of such a policy in the long run could be a sluggish economy and
high unemployment levels. Nonetheless, the process continues as the government uses its fiscal
policy to fine tune spending and taxation levels, with the goal of evening out the business cycles.
Who Does Fiscal Policy Affect?
Unfortunately, the effects of any fiscal policy are not the same on everyone. Depending on the
political orientations and goals of the policymakers, a tax cut could affect only the middle class, which
is typically the largest economic group. In times of economic decline and rising taxation, it is this same
group that may have to pay more taxes than the wealthier upper class.
Similarly, when a government decides to adjust its spending, its policy may affect only a specific
group of people. A decision to build a new bridge, for example, will give work and more income to
hundreds of construction workers. A decision to spend money on building a new space shuttle, on the
other hand, benefits only a small, specialized pool of experts, which would not do much to increase
aggregate employment levels.
Conclusion
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.
(For the latest on U.S. and global economic conditions, try the Economic Section at Forbes.com.)
by Reem Heakal (Contact Author | Biography) ?
Bonds, Economics, Retirement
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