Fiscal Policy, Meaning, Types, Working, Factors Affecting
Read all you need to know about fiscal policy. Understand the significance of it and how governments use fiscal policy to control inflation.
Izhar Ahmad15 Dec, 2023
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Fiscal policy involves the use of government spending and taxation policies aimed at affecting overall macroeconomic conditions. This implies controlling the demand for goods and services, employment, inflation, as well as overall economic development.
Governments may lower taxes or increase spending to boost demand and economic growth, particularly in periods of depression in the economy. During inflationary periods, the government can either increase interest rates or reduce expenditures for the purpose of restraining economic activities.Start your Commerce career with PW Online Course. Enroll now to build a successful future in Commerce.
What is Fiscal Policy?
Fiscal policy refers to how a government plans to control its expenditures as well as the taxes to be levied in order to track and shape the path of an economy. It complements the monetary policy which is the way the central bank adjusts the money amount in the country. These measures are geared towards ensuring that a given country realizes its economic goals.Types of Fiscal Policy
There are generally the following types of fiscal policy:Discretionary:
Discretionary fiscal policy is when the government changes spending or tax rates without having to make a conscious choice, like when they pass a law.Expansionary:
Using fiscal instruments to boost the economy by increasing general demand leads to more production, lower unemployment, and higher prices. This is called expansionary fiscal policy. This strategy is applied to handle economic recessions.Contractionary :
Conversely, contractionary fiscal policy is the application of fiscal means that contract the economy by lowering consumer demand. This leads to reduced output, increased unemployment, and a lower price level. Contractionary fiscal policy is adopted to combat economic booms.How Fiscal Policy Works?
In order to understand how fiscal policy works, we have provided a few situation-based examples below:Situation 1: Addressing Economic Downturn
Imagine you're currently unemployed due to a lack of job opportunities, leading to reduced spending at local businesses. This, in turn, affects the income of the shopkeeper, who postpones purchasing a desired item, causing a ripple effect. To counter such recessions, the government can: Increase government spending: By investing in projects like building hospitals and schools, the government generates new job opportunities, stimulating economic activity. As you secure a job in these sectors, your spending boosts the income of local businesses, creating a positive chain reaction. Decrease taxes: Alternatively, reducing taxes means you take home a larger portion of your salary, encouraging increased spending. Lowering taxes on goods can also prompt people to buy more, fostering economic growth.Situation 2: Managing Inflation
Now, picture a situation where both you and your friend are employed and looking for the last available earphones at a local shop. The shopkeeper decides to sell it to the highest bidder, creating a scenario similar to inflation—your money buys less than it did before. To counter inflation, the government may: Decrease government spending: Cutting spending can lead to a contraction in job opportunities, potentially resulting in unemployment or reduced salaries. This, in turn, affects overall spending and demand for goods and services. Increase taxes: Raising taxes means the government takes a larger share of your salary, reducing your disposable income. Consequently, people tend to spend less, causing a decline in the demand for goods and services and, consequently, lowering prices.Looking for the Best Commerce Coaching?
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Factors Reducing the Effectiveness of Fiscal Policy
Data Delay: The time taken to collect data on a nation's economic status, such as changes in consumer confidence, can impede fiscal policy implementation. Recognition Delay: Identifying problems based on reports, such as unemployment and real GDP changes, may be delayed, leading to uncertainties about whether the issues are temporary or indicative of a long-term trend. Decision Delay: After assessing the situation, policymakers face the challenge of determining the appropriate course of action, whether to wait for self-correction mechanisms or intervene through measures like tax cuts or increased spending. This decision-making process, coupled with legislative involvement, introduces additional delays. Implementation Delay: Once a spending bill is passed, the implementation phase involves establishing new agencies and executing initiatives, such as infrastructure development programs. Decisions on specifics, like bridge locations and road construction, contribute to further delays in the overall fiscal policy execution.Key Points on Fiscal Policy
- Fiscal policy includes the government changing both tax rates and spending levels to oversee and impact the nation's economy.
- Through a mix of fiscal and monetary policies, the government can successfully watch various economic occurrences.
- The effects of economic policy are not uniform across the population. Depending on lawmakers' goals and party leanings, a tax decrease, for instance, may directly affect the middle class, often the biggest economic section.
- It appears in three main forms—discretionary fiscal policy, contractionary fiscal policy, and expansionary fiscal policy—each designed to address specific economic situations and goals.
Fiscal Policy FAQs
What exactly is fiscal policy in the budget?
Fiscal policy is the use of revenue from government (mostly taxes, but also non-tax earnings like divestment and loans) and spending to impact the economy.
What are the four fiscal policy instruments?
The primary instruments of fiscal policy are (i) taxes, (ii) spending (i.e. transfers of money to state governments and direct government consumption), and (iii) borrowing or loans.
What are the objectives of fiscal policy?
The primary objective of fiscal policy is to maintain economic stability, employment, and a stable growth rate.
What exactly is a liquidity trap?
A liquidity trap is a scenario in which interest rates are very low while savings are extremely high. In other words, even with interest rates at or near 0%, individuals and companies are hanging onto their cash.
In economics, what is helicopter money?
Helicopter money refers to a huge amount of new money that is produced and given to the general people in order to boost the economy during a recession or when interest rates fall to zero.
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