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What is Fiscal Policy?

fiscal policy Fiscal policy is the use of government revenue and spending to influence the economy. / Credit: Lightspring | Shutterstock.com

One of the factors that helps determine the country's economic direction is fiscal policy. The government uses fiscal policy to influence the economy by adjusting revenue and spending levels. In the United States, both the executive and legislative branches of the government determine fiscal policy.

Fiscal policy is based on the theories of British economist John Maynard Keynes, which state that increasing or decreasing revenue (taxes) and expenditures (spending) levels influences inflation, employment and the flow of money through the economic system. Fiscal policy is often used in combination with monetary policy, which in the United States is set by the Federal Reserve, to influence the direction of the economy and meet economic goals.

The two main tools of fiscal policy are taxes and spending. Taxes influence the economy by determining how much money the government has to spend in certain areas and how much money individuals have to spend. For example, if the government is trying to spur spending among consumers, it can decrease taxes. A cut in taxes provides families with extra money, which the government hopes they will turn around and spend on other goods and services, thus spurring the economy as a whole.

Spending is used as a tool for fiscal policy to drive government money to certain sectors that need an economic boost. Whoever receives those dollars will have extra money to spend – and, as with taxes, the government hopes that money will be spent on other goods and services. The key is finding the right balance and making sure the economy doesn't lean too far either way. Prior to the Great Depression in the 1920s, the U.S. government took a very hands-off approach when it came to setting economic policy. Afterward, the U.S. government decided it needed to play a larger role in determining the direction of the economy.

Types of fiscal policy

There are two main types of fiscal policy: expansionary and contractionary. Expansionary fiscal policy, designed to stimulate the economy, is most often used during a recession, times of high unemployment or other low periods of the business cycle. It entails the government spending more money, lowering taxes, or both. The goal is to put more money in the hands of consumers so they spend more and stimulate the economy.

Contractionary fiscal policy is used to slow down economic growth, such as when inflation is growing too rapidly. The opposite of expansionary fiscal policy, contractionary fiscal policy raises taxes and cuts spending.

Setting fiscal policy

Today's U.S. fiscal policies are tied into each year's federal budget. The federal budget spells out the government’s spending plans for the fiscal year and how it plans to pay for that spending, such as through new or existing taxes. The budget is developed through a collaborative effort between the president and Congress.

The president will first submit a budget to Congress that sets the tone for the coming year's fiscal policy by outlining how much money the government should spend on public needs, such as defense and health care; how much the government should take in in tax revenues; and how much of a deficit, or surplus, is projected. Congress then reviews the president's budget request and develops its own budget resolutions, which set broad levels for spending and taxation. Once those are approved, legislators start the appropriations process, which spells out where each dollar will be spent. The president must sign those appropriations bills before they can be enacted.

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Chad Brooks

Chad Brooks is a Chicago-based writer who has nearly 15 years' experience in the media business. A graduate of Indiana University, he spent nearly a decade as a staff reporter for the Daily Herald in suburban Chicago, covering a wide array of topics including, local and state government, crime, the legal system and education. Following his years at the newspaper Chad worked in public relations, helping promote small businesses throughout the U.S. Follow him on Twitter.