Mouse-over a link for a quick definition or click to read more in-depth!
The government’s use of its taxing and spending power to influence economic activity.
Who controls fiscal policy?
- It varies from country to country, but it ultimately comes down to who has power to tax and to spend government money. Those who have power over the budget are called the fiscal authority.
- In the US the power is shared by the executive and the legislative branches.
- There are different models throughout Europe, but in most cases the power is held in varying degrees by the prime minister or the finance minister and parliament. The degree of power held by either of these entities changes through time.
Why is fiscal policy conducted?
- People look to the government to control and to minimize economic fluctuations through its legislative power of taxation and government spending. When the action is undertaken to minimize economic fluctuation, it is called discretionary fiscal policy.
- To address a pressing budgetary balance or debt concern.
How is fiscal policy conducted?
- The fiscal authority legislates an increase or decrease in either taxes or spending. Thus the tools of the fiscal authority are spending and taxing.
What are the effects of fiscal policy on the economy?
- Let’s say the government cuts your taxes – you have more money to spend so you go buy things – this causes output to increase and the stores you go to produce more of whatever you bought. To build more the firms must hire more workers so unemployment goes down. Your increased demand also causes prices to increase. If everyone in the economy gets the same tax cut then the output increase and price increase is felt across the whole economy. The tax cut has shifted the aggregate demand curve out by increasing consumption. In this way the government can use taxes to overcome economic fluctuations in unemployment and prices.
- A spending increase is similar to a tax cut, except that the government cuts out the first step where you get the money initially. Instead, the government starts buying things, causing an increase in output, inflation, and a reduction in unemployment. In this way, the government shifts out the aggregate demand curve by increasing government spending.
- Sometimes the government does not have to do anything because automatic stabilizers kick in, which dampen economic fluctuations.
General difficulties in conducting fiscal policy
- Influencing economic activity is not a government’s only goal. Governments also provide social services and national defense. They are concerned with wealth redistribution and economic equality. They are concerned with the budgetary balance and the amount of outstanding public debt. Some of these priorities may interfere with using policy to smooth economic fluctuations.
- Governments are under more pressure to act, and more apt to conduct fiscal policy, when there is high unemployment. To lower Okun's Law the government usually has to run a budget deficit.
- It takes a long time to legislate a change in taxes or spending. By the time the fiscal authorities agree upon an appropriate fiscal policy, the problems in the economy could be completely different (this is called a long inside lag).