What is Fiscal Policy?

Market economies regularly cycle between expansion and contraction.  Elsewhere we discuss two negative consequences of an economic contraction – the loss of potential production and unemployment.  But even too-rapid expansions have a potential downside.  As we saw in the section “what is full employment”, increasing production beyond full employment can drive up wages and potentially lead to inflation.  And so, policy makers ideally would like to smooth out the cycle, eliminating both contractions and over-expansions.

But how to cool an overheated economy?  Or jump start one that has stalled?  At the root of all economic activity is spending.  During an over-expansion, spending is increasing faster than the production capacity of the economy.  During a contraction, spending for some reason has stopped.  And so, counter-cyclical policy entails either causing a decrease or increase in spending as appropriate. 

There are two types of policy available to accomplish this.  The first we’ll discuss during the final two weeks of the class, monetary policy.  Monetary policy is the deliberate manipulation of the money supply and, in turn, interest rates for the purpose of increasing or decreasing spending by consumers and businesses.  The second, fiscal policy, we’ll cover now.   

Fiscal policy is the direct manipulation of either government spending or tax collection.  The term “fiscal” refers to budgeting.  In accounting, you’ll hear the term fiscal year used to refer to the budget year of a business.  In the context of fiscal policy, it refers to the intentional manipulation of the two things that impact the government’s budget – its spending and its collection of taxes.  A change in either affects the government budget and so is “fiscal” policy. 

So, how might fiscal policy help address an economic contraction?  During the early 1930s, the United States went through its worst economic contraction ever.  The collapse of the stock market and declining real estate prices led to the failure of a full third of all banks in the country.  As this was before the introduction of deposit insurance, many depositors at these banks were wiped out.  The households who did still have money held on to it, stopping almost all non-essential spending.  And with this collapse in household spending, businesses were not going to invest in new plant and equipment.  The economy therefore ground to a halt and unemployment increased to over 20% of the labor force.  The photo below, one of many like it from this era, shows a large group of customers waiting outside a Minneapolis bank hoping to withdraw their savings before the bank collapsed. 

Courtesy Investopedia.com

In 1933, Franklin D. Roosevelt become the 32nd president of the United States.  His most enduring legacy was the introduction of the New Deal, a series of social reforms, public works projects, and regulations intended to directly address both the causes and consequences of the what we now refer to as the Great Depression.   

If households and businesses are unwilling or unable to spend, so the policy reasoned, the government must step in as a spender of last resort.  And so, in 1933 the US government began a series of large government works programs with sole intention of putting the unemployed to work, creating wages that would be spend, and so stimulate the private economy.  Much of the infrastructure in the US national parks, roads, bridges, and even the completion of Hoover dam were all major New Deal projects.  The following photo shows a group of young members of the Civilian Conservation Corp (CCC). 

In addition to public spending, expansionary fiscal policy during a contraction might also include a reduction in tax collection.  During both the 2008 and more recent Covid crisis, the government returned tax revenue to households in the form of “stimulus checks”.  Those who advocate for tax reduction do so based on the belief that households will spend the money that would otherwise have been used to pay taxes.  And so, an expansionary fiscal policy is some combination of an increase in government spending and a decrease in the collection of taxes. 

2020 Stimulus Check Example

The success of the New Deal as a remedy for the Great Depression will never be fully know.  The entry of the United States into the second world war immediately removed any excess labor from the economy and provided a large economic stimulus as the country began the rapid production of armaments. 

While it is possible to imagine a contractionary fiscal policy – concurrent increase in taxes while decreasing government spending – it’s really hard to imagine such a thing would ever pass through congress or be signed by the president.  Both policies are politically unpopular and so politically unrealistic.  And so, fiscal policy is almost exclusively a tool used to combat economic contractions.