Fiscal Policy

Policy aimed at changing the level of either government spending or taxes to stimulate or slow down the economy is known as fiscal policy. It was invented by the British economist John Maynard Keynes in the 1930s. Keynes believed that increased demand for goods and services should be met by expanded production. However, after a nation's economy reaches full capacity, production cannot expand. If the demand for goods and services increases, prices continue to rise and inflation occurs. In such cases, Keynes recommended a tax increase, which would reduce the demand for goods and services and relieve the pressure on prices.

Keynes maintained that governments should use fiscal policy (tax and spending programs) to stabilize the economy. He said the overall level of economic activity depends on effective demand – that is, total spending by individuals, businesses, and government.

To understand how fiscal policy works, we need to understand three basic concepts. First, the deficit. When government spending is greater than tax revenue, we have a federal budget deficit. The government is paying out more than it is taking in. How does it make up the difference? It borrows. Deficits have been much more common than surpluses. This is not to say that deficits are always bad. Indeed, during recessions, they are just what the economic doctor ordered.

Second, budget surpluses are the exact opposite of deficits. They are prescribed to fight inflation. When the budget is in a surplus position, tax revenue is greater than government spending.

Finally, we have a balanced budget when government expenditures are equal to tax revenue.

Thus, fiscal policy is the manipulation of the government budget deficit or surplus to influence the level of aggregate income (or GDP) in the economy. If aggregate income is too low (actual income is below target income), the appropriate fiscal policy is expansionary fiscal policy: to increase the deficit, or to reduce a surplus, which means the government spends more or takes in less. If aggregate income is too high (actual income is above target income), the appropriate fiscal policy is contractionary fiscal policy: to reduce the deficit, or to increase a surplus, which means the government takes in more in taxes or spends less.

Expansionary and contractionary fiscal policies are two basic types of discretionary fiscal policy, which is the deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy.

Exhibit 1 lists these types of fiscal policy and the corresponding ways in which the government can pursue each of these options.

Exhibit 1.