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What is fiscal policy?

Everything you need to know about fiscal policy explained.

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Fiscal policy refers to a government’s approach to public spending and taxation, and how these influence economic conditions such as inflation, employment, and demand for goods and services.

Generally, fiscal policy is used to promote and stimulate economic growth while reducing poverty, or it’s used reactively to mitigate the effects of global economic shocks or downturns.

Key takeaways from this section
    • A fiscal policy is how a government influences economic conditions through public spending and taxation policies.
    • Fiscal policy is largely based on Keynesian economics, based on ideas from the economist John Maynard Keynes.
    • Governments can employ expansionary or contractionary fiscal policies to counteract the effects of economic downturns or restrain runaway economic growth and inflation.

Understanding Fiscal Policy

Fiscal policy as a tool of governments has grown in use since the economic crises of the 20th century, such as the Great Depression. More recently, governments have tended to take more active roles in fiscal policy as a response to global recessions and political shifts.

Most modern fiscal policies are heavily based on the ideas of John Maynard Keynes, a British economist of the early 20th century who promoted the concept of governments taking an active role in their economies with a system that became known as Keynesian economics. Keynes made the case that governments should be able to regulate the economic output of a nation by adjusting spending and taxation, and thus weather recessions by making up for shortfalls in the private sector. This was in opposition to the previously held belief that markets and national economies could balance themselves and self-correct in the face of downturns.

There are many factors that can cause an economy to shrink or fall into recession, from changing political climates, to consumer fear or uncertainty, to natural disasters and more. A crash can also be preceded by runaway excess and unsustainable economic growth. Fiscal policy is designed to counteract these effects and manage the dips and rises through public spending and taxation.

Stabilising an economy through Fiscal Policy

If an economy is taking a nosedive due to a loss of demand in the private sector, a government could invest heavily in public projects and reduce taxation to stimulate growth and increase demand. If the private sector is growing too much and over-investing, the government can increase taxes and reduce public spending to temper demand.

This usually means governments need to run a budget deficit during economic downturns, known as an expansionary fiscal policy, and run a budget surplus during periods of growth, or a contractionary fiscal policy.

Expansionary and Contractionary Fiscal Policy

Expansionary Fiscal Policy

An expansionary fiscal policy aims to mitigate the effects of an economic downturn by stimulating demand and growth. Lowering taxes can mean consumers have more money to spend, thus creating more demand and fuelling growth through increased employment. Likewise, an increase in government spending, such as on public infrastructure projects, also fuels employment and a growth in demand. This also means running public finances at a deficit during tough economic times.

Expansionary Fiscal Policy

A contractionary fiscal policy seeks to restore some balance to the economy in the face of runaway growth and inflation and the threat of an economic crash. This can be done through an increase in taxes and a reduction in public spending, as well as reducing the public sector workforce or cutting wages. Interest rates can also be raised to restrict the supply of credit and slow inflation. This usually results in a government running a budget surplus, which can also raise public opinion issues in the face of wage cuts and increased taxes.

Fiscal Policy FAQs

Who creates a fiscal policy?

Fiscal policy is a tool of government, and usually the responsibility of the Treasury along with direction from the Prime Minister and the Cabinet. The budget also has to be scrutinised and approved by Parliament before its fiscal policy changes can be enacted.

Why do we need fiscal policy?

Fiscal policy is an important method for government to be able to influence and manage the economy, helping to stimulate growth and demand, and mitigate the impacts of financial crashes or other disasters that could otherwise cause greater harm.

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