Debitoor's accounting dictionary
Fiscal policy

Fiscal policy - What is fiscal policy?

Fiscal policy refers to a government’s influence over an economy through tax and spending choices and actions

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Fiscal policy is closely tied to monetary policy, which refers to the supply of money in a particular society and its impact on the economy. Fiscal policy originated with the theories of John Maynard Keynes, the famous British economist. He puts forth the idea that a government can manage the growth of an economy through tax and spending.

Where fiscal policy involves governmental implementation of tax adjustments as well as the amount of money put into public spending, monetary policy involves interest rates, money supply, and the impact on the individual.

Why use fiscal policy?

When used properly, the management of a good fiscal policy can lead to numerous positive outcomes including:

  • Putting a stop to inflation
  • Improves employment
  • Encourage economic growth

In other words, fiscal policy goes towards stabilising the economy. However, it is rare that fiscal policy is used on its own - it is most often used in conjunction with monetary policy (which can be used on its own).

Developing a fiscal policy

The key to creating fiscal policy is balance. The government aims to balance taxation and public spending in order to have an intended impact on the economy. To put it very simply:

  • When public spending goes up, tax falls
  • When public spending falls, tax goes up

These two strategies cause a specific reaction in the economy: that it either expands (from the former) or contracts (from the latter).

Expansionary fiscal policy

This type of fiscal policy is used to encourage growth in an economy. It is used arguably more than contractionary fiscal policy, and is used to bring about an end to periods of economic recession.

To implement expansionary fiscal policy, governments typically cut taxes to provide people with more spending money, or begin putting more money into the economy themselves. This is often in the form of infrastructure (schools, roads, bridges, etc.). Often both methods are used to increase purchasing power, improve business performance, thereby creating more jobs, and so on.

Contractionary fiscal policy

While it might seem like a negative fiscal policy (and is rarely implemented), contractionary fiscal policy can play a very important role. It is enacted when inflation becomes a bit out of control.

The reason that inflation should be slowed is because it can ultimately have a negative impact on quality of life.

Contractionary fiscal policy means increased tax, which leads to a reduction of spending power, for individuals, businesses, and even government. It is generally not a popular choice but can be useful if used appropriately in certain circumstances.

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