Fiscal policy is the use of government spending and tax policies to influence economic conditions. Like the central bank, the government can pursue an expansionary or contractionary fiscal policy.
When the economy is weak the government can lower taxes to encourage people to spend or invest because their disposable income (income minus taxes) increases making them feel wealthier.
This can
help demand to grow making businesses to hire workers and causing even more
demand as people start to see a better environment eventually helping the
overall economy. The government can also increase spending like for example for
infrastructure that increases employment pushing up demand and overall growth.
Such expansionary fiscal policy is associated with deficit spending. This means that the government spends more than it earns through taxes and borrows the rest from the open market selling bonds. This eventually creates debt that will need to be repaid in the future.
On the other hand, when the economy is strong the government can increase taxes and lower spending therefore slowing down demand and growth. Unfortunately, contractionary fiscal policy is rarely used because it’s politically unpopular as people most likely wouldn’t want to vote for a government that raises taxes. This is one of the reasons why government debt eventually grows gradually.
Generally, it’s the central bank that pursues a contractionary monetary policy to slow demand and growth and that’s also why an independent central bank is vital as it’s not aiming for political approval but just to make sure the economy remains stable.
This article was written by Giuseppe Dellamotta.
