Fiscal Policy The Concise Encyclopedia of Economics. Fiscal policy is the use of government spending and taxation to influence the economy. When the government decides on the goods and services it purchases, the transfer payments it distributes, or the taxes it collects, it is engaging in fiscal policy. The primary economic impact of any change in the government budget is felt by particular groupsa tax cut for families with children, for example, raises their disposable income. Discussions of fiscal policy, however, generally focus on the effect of changes in the government budget on the overall economy. Although changes in taxes or spending that are revenue neutral may be construed as fiscal policyand may affect the aggregate level of output by changing the incentives that firms or individuals facethe term fiscal policy is usually used to describe the effect on the aggregate economy of the overall levels of spending and taxation, and more particularly, the gap between them. Fiscal policy is said to be tight or contractionary when revenue is higher than spending i. Often, the focus is not on the level of the deficit, but on the change in the deficit. Thus, a reduction of the deficit from 2. Figure 1 shows the federal budget surplus over the period 1. The data in the figure are corrected to remove the effects of business cycle conditions. For example, in fiscal year 2. How Does Stimulus Programs Affect The Money Supply' title='How Does Stimulus Programs Affect The Money Supply' />The data are also standardized to eliminate the effects of inflation and the effects of quirks in the timing of revenues and outlays, such as the receipt of payments from Desert Storm allies that arrived in the fiscal years following the war itself. Notable on the figure are the fiscal stimulus of the Vietnam War, the Kemp Roth tax cuts of the early 1. A. A1C A form of hemoglobin used to test blood sugars over a period of time. ABCs of Behavior An easy method for remembering the order of behavioral components. Save Game Editing Crusader Kings 2. George W. Bush. The most immediate effect of fiscal policy is to change the aggregate demand for goods and services. A fiscal expansion, for example, raises aggregate demand through one of two channels. First, if the government increases its purchases but keeps taxes constant, it increases demand directly. How Does Stimulus Programs Affect The Money Supply' title='How Does Stimulus Programs Affect The Money Supply' />Second, if the government cuts taxes or increases transfer payments, households disposable income rises, and they will spend more on consumption. This rise in consumption will in turn raise aggregate demand. Fiscal policy also changes the composition of aggregate demand. When the government runs a deficit, it meets some of its expenses by issuing bonds. Finance Development. Mark Horton and Asmaa ElGanainy. Governments use spending and taxing powers to promote stable and sustainable growth. How Does Stimulus Programs Affect The Money Supply' title='How Does Stimulus Programs Affect The Money Supply' />In doing so, it competes with private borrowers for money loaned by savers. Holding other things constant, a fiscal expansion will raise interest rates and crowd out some private investment, thus reducing the fraction of output composed of private investment. In an open economy, fiscal policy also affects the exchange rate and the trade balance. In the case of a fiscal expansion, the rise in interest rates due to government borrowing attracts foreign capital. In their attempt to get more dollars to invest, foreigners bid up the price of the dollar, causing an exchange rate appreciation in the short run. This appreciation makes imported goods cheaper in the United States and exports more expensive abroad, leading to a decline of the merchandise trade balance. Foreigners sell more to the United States than they buy from it and, in return, acquire ownership of U. S. assets including government debt. In the long run, however, the accumulation of external debt that results from persistent government deficits can lead foreigners to distrust U. S. assets and can cause a deprecation of the exchange rate. Figure 1 Cyclically Adjusted and Standardized Budget Surplus as a Percentage of GDP 1. Source Congressional Budget Office, Washington, D. C. Fiscal policy is an important tool for managing the economy because of its ability to affect the total amount of output producedthat is, gross domestic product. The first impact of a fiscal expansion is to raise the demand for goods and services. This greater demand leads to increases in both output and prices. The degree to which higher demand increases output and prices depends, in turn, on the state of the business cycle. If the economy is in recession, with unused productive capacity and unemployed workers, then increases in demand will lead mostly to more output without changing the price level. If the economy is at full employment, by contrast, a fiscal expansion will have more effect on prices and less impact on total output. This ability of fiscal policy to affect output by affecting aggregate demand makes it a potential tool for economic stabilization. In a recession, the government can run an expansionary fiscal policy, thus helping to restore output to its normal level and to put unemployed workers back to work. During a boom, when inflation is perceived to be a greater problem than unemployment, the government can run a budget surplus, helping to slow down the economy. Such a countercyclical policy would lead to a budget that was balanced on average. Automatic stabilizersprograms that automatically expand fiscal policy during recessions and contract it during boomsare one form of countercyclical fiscal policy. Unemployment insurance, on which the government spends more during recessions when the unemployment rate is high, is an example of an automatic stabilizer. Similarly, because taxes are roughly proportional to wages and profits, the amount of taxes collected is higher during a boom than during a recession. Thus, the tax code also acts as an automatic stabilizer. But fiscal policy need not be automatic in order to play a stabilizing role in business cycles. Some economists recommend changes in fiscal policy in response to economic conditionsso called discretionary fiscal policyas a way to moderate business cycle swings. These suggestions are most frequently heard during recessions, when there are calls for tax cuts or new spending programs to get the economy going again. Unfortunately, discretionary fiscal policy is rarely able to deliver on its promise. Fiscal policy is especially difficult to use for stabilization because of the inside lagthe gap between the time when the need for fiscal policy arises and when the president and Congress implement it. If economists forecast well, then the lag would not matter because they could tell Congress the appropriate fiscal policy in advance. But economists do not forecast well. Absent accurate forecasts, attempts to use discretionary fiscal policy to counteract business cycle fluctuations are as likely to do harm as good. The case for using discretionary fiscal policy to stabilize business cycles is further weakened by the fact that another tool, monetary policy, is far more agile than fiscal policy. Whether for good or for ill, fiscal policys ability to affect the level of output via aggregate demand wears off over time. Higher aggregate demand due to a fiscal stimulus, for example, eventually shows up only in higher prices and does not increase output at all. That is because, over the long run, the level of output is determined not by demand but by the supply of factors of production capital, labor, and technology. These factors of production determine a natural rate of output around which business cycles and macroeconomic policies can cause only temporary fluctuations. An attempt to keep output above its natural rate by means of aggregate demand policies will lead only to ever accelerating inflation. The fact that output returns to its natural rate in the long run is not the end of the story, however.