Fiscal policy

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In economics, fiscal policy is the use of government expenditure and revenue collection to influence the economy.[1]

Fiscal policy can be contrasted with the other main type of macroeconomic policy, monetary policy, which attempts to stabilize the economy by controlling interest rates and the money supply. The two main instruments of fiscal policy are government expenditure and taxation. Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

  • Aggregate demand and the level of economic activity;
  • The pattern of resource allocation;
  • The distribution of income.

Fiscal policy refers to the use of the government budget to influence the first of these: economic activity.


Stances of fiscal policy

The three possible stances of fiscal policy are neutral, expansionary and contractionary. The simplest definitions of these stances are as follows:

  • A neutral stance of fiscal policy implies a balanced economy. This results in a large tax revenue. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.
  • An expansionary stance of fiscal policy involves government spending exceeding tax revenue.
  • A contractionary fiscal policy occurs when government spending is lower than tax revenue.

However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclical fluctuations of the economy cause cyclical fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral fiscal policy stance.

Methods of funding

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:

  • Taxation
  • Seigniorage, the benefit from printing money
  • Borrowing money from the population or from abroad
  • Consumption of fiscal reserves.
  • Sale of fixed assets (e.g., land).

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