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Robert Longley is a U.S. government and history expert with over 30 years of experience in municipal government and urban planning.
Published on October 28, 2021Fiscal policy is the use of government spending and taxation to influence the country’s economy. Governments typically strive to use their fiscal policy in ways that promote strong and sustainable growth and reduce poverty.
Fiscal policy is used to influence the “macroeconomic” variables—inflation, consumer prices, economic growth, national income, gross domestic product (GDP), and unemployment. In the United States, the importance of these uses of government revenues and spending developed in response to the Great Depression, when the laissez-faire, or “leave it alone,” approach to government economic control espoused by Adam Smith became unpopular. More recently, the role of fiscal policy gained prominence during the global economic crisis of 2007-2009, when governments intervened to support financial systems, encourage economic growth, and offset the impact of the crisis on vulnerable groups.
Modern fiscal policy is based largely on the theories of the British economist John Maynard Keynes, whose liberal Keynesian economics correctly theorized that government management of changes in taxation and spending would influence supply and demand and the overall level of economic activity. Keynes' ideas led to U.S. President Franklin D. Roosevelt’s depression-era New Deal programs involving massive government spending on public works projects and social welfare programs.
Governments attempt to design and apply their fiscal policy in ways that stabilize the country’s economy throughout the annual business cycle. In the United States, responsibility for fiscal policy is shared by the executive and legislative branches. In the executive branch, the office most responsible for fiscal policy is the President of the United States along with the Cabinet-level Secretary of the Treasury and a presidentially appointed Council of Economic Advisers. In the legislative branch, the U.S. Congress, using its constitutionally granted “power of the purse,” authorizes taxes and passes laws appropriating funding for fiscal policy measures. In Congress, this process requires participation, debate, and approval from both the House of Representatives and the Senate.
In contrast to fiscal policy, which deals with taxes and government spending levels and is administered by a government department, monetary policy deals with the country’s money supply and interest rates and is often administered by the country’s central banking authority. In the United States, for example, while fiscal policy is administered by the president and Congress, monetary policy is administered by the Federal Reserve, which plays no role in fiscal policy.
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Governments use a combination of fiscal and monetary policy to control the country’s economy. To stimulate the economy, the government’s fiscal policy will cut tax rates while increasing its spending. To slow down a “runaway” economy, it will raise taxes and reduce spending. Should it becomes necessary to stimulate a receding economy, the central bank will alter its monetary policy, often by lowering interest rates thus increasing the money supply and making it easier for consumers and businesses to borrow. If the economy is growing too quickly, the central bank will raise interest rates thus removing money from circulation.
In the United States, Congress has set maximum employment and price stability as the primary macroeconomic objectives of the Federal Reserve. Otherwise, Congress determined that monetary policy should be free from the influence of politics. As a result, the Federal Reserve is an independent agency of the federal government.
Ideally, fiscal and monetary policy work together to create an economic environment in which growth remains positive and stable, while inflation remains low and stable. The government’s fiscal planners and policymakers strive for an economy free from economic booms that are followed by extended periods of recession and high unemployment. In such a stable economy, consumers feel secure in their buying and saving decisions. At the same time, corporations feel free to invest and grow, creating new jobs and rewarding their bondholders with regular premiums.
In the real world, however, the rise and fall of economic growth are neither random nor unexplainable. The economy of the United States, for example, naturally goes through regularly repeating phases of business cycles highlighted by periods of expansion and contraction.
During periods of expansion, real gross domestic product (GDP) grows for two or more consecutive quarters, as the underlying economy moves from “troughs” to “peaks.” Typically accompanied by increasing employment, consumer confidence, and the stock market, expansion is considered to be a period of economic growth and recovery.
Expansions typically occur as the economy is moving out of a recession. To encourage expansion, the central bank—the Federal Reserve in the United States—lowers interest rates and adds money to the financial system by purchasing Treasury bonds in the open market. This replaces bonds held in private portfolios with cash the investors put in banks that are then eager to loan this extra money. Businesses take advantage of the availability of the banks’ low-interest rate loans to purchase or expand factories and equipment and to hire employees so they can produce more products and services. As the GDP and per capita income grows, unemployment declines, consumer start spending, and the stock markets perform well.
According to the National Bureau of Economic Research (NBER), expansions typically last about 5 years but have been known to last as long as 10 years.
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Expansionary economic policy is popular, making it politically hard to reverse. Even though expansionary policy usually increases the country’s budget deficit, voters like low taxes and public spending. Proving true the old saying that “all good things must end,” expansion can get out of control. The flow of cheap money and increased spending causes inflation to rise. High inflation and the risk of widespread loan defaults can badly damage the economy, often to the point of recession. To cool the economy and prevent hyperinflation, the central bank raises interest rates. Consumers are encouraged to cut back on spending to slow down economic growth. As corporate profits fall, stock prices decline, and the economy goes into a period of contraction.
Commonly considered a recession, a contraction is a period during which the economy as a whole is in decline. Contractions usually occur after an expansion hits its “peak”. According to economists, when a country’s GDP has declined for two or more consecutive quarters, then a contraction becomes a recession. As the central bank raises interest rates, the money supply shrinks, and companies and consumers cut back on borrowing and spending. Instead of using their profits to grow, hire, and increase production, businesses add it to the money they accumulated during the expansion and use it for research and development, and other steps in anticipation of the next expansion phase. When the central bank determines that the economy has “cooled” enough that the business cycle has reached a “trough,” it lowers interest rates to add money to the system, hopefully ending the recession and starting the next expansion.
For most people, an economic contraction brings some degree of financial hardship as unemployment increases. The longest and most painful period of contraction in modern American history was the Great Depression, from 1929 to 1933. The recession of the early 1990s also lasted eight months, from July 1990 through March 1991. The recession of the early 1980s lasted 16 months, from July 1981 through November 1982. The Great Recession of 2007 to 2009 was 18 months of substantial contraction spurred by the collapse of the housing market—fueled by low-interest rates, easy credit, and insufficient regulation of subprime mortgage lending.
