A1.4.2. Fiscal Policy
Fiscal policy refers to a government’s policy of using taxes and spending to affect economic performance. While both fiscal policy and monetary policy represent attempts by governments to manage their economies, they are distinct. Fiscal policy is based on the theories of the twentieth-century British economist John Maynard Keynes, and for this reason, the use of fiscal policy is often referred to as Keynesian economics.
The basic theory of fiscal policy is that a country’s economic output, and thus business cycles, unemployment, inflation, and other economic indicators are related to aggregate demand. Aggregate demand is the total demand in the entire country for all “final” goods and services—in other words, goods and services that are wanted for their own sake and not as a component for something else. For example, demand for laptop computers counts toward aggregate demand, but demand for microchips does not. Essentially, if aggregate demand is insufficient, recession and unemployment follow. If aggregate demand is too high, inflation results.
Like monetary policy, fiscal policy may be expansionary or contractionary. An expansionary fiscal policy increases government spending and/or reduces taxes in an effort to increase aggregate demand and perk up a slow economy. This is the stated intent behind government stimulus measures. Expansionary fiscal policy almost inevitably increases government deficits. A contractionary fiscal policy results in reduced government spending and/or higher taxes, which may slow down the economy and produce a government surplus. A balanced budget policy generally is, or is intended to be, neutral from a fiscal policy standpoint.
Government revenues fluctuate based on economic factors. For example, during an economic boom, taxes collected may increase, even though tax rates have not changed. The resulting impact on a government’s budget is not considered to be the result of fiscal policy.