Fiscal policy is the use of government spending and taxation to influence aggregate demand, employment, inflation and economic growth within an economy. It is enacted by a government’s treasury or finance ministry through budgets that adjust expenditure programmes, tax rates and public borrowing, and it is the principal counterpart to the monetary policy operated by a central bank. Expansionary fiscal policy raises spending or cuts taxes to stimulate a weak economy, while contractionary policy does the reverse to restrain overheating or reduce public debt.
Overview
- Fiscal policy operates on the demand side of the economy through the government budget, complementing the monetary policy of the central bank.
- Its principal instruments are public spending, taxation and the resulting level of public borrowing and debt.
- Discretionary measures are supplemented by automatic stabilisers such as progressive taxes and unemployment benefits that dampen the cycle without new legislation.
Key aspects
- Expansionary stance: increased spending or tax cuts raise aggregate demand to combat recession and unemployment.
- Contractionary stance: reduced spending or higher taxes restrain demand to control inflation or reduce deficits.
- Budget balance: the gap between revenue and expenditure determines borrowing needs and the trajectory of public debt.
- Coordination: fiscal and monetary policy interact, and credibility of debt sustainability shapes their effectiveness.
Applications
- Stabilising output and employment over the business cycle.
- Funding public goods, infrastructure and welfare programmes.
- Counter-cyclical stimulus during downturns and consolidation during expansions.
- Influencing income distribution through the structure of taxes and transfers.