fiscal policy

Imagine the whole economy as a giant household, and the government as one very large member of it. That member collects money from everyone (taxes) and spends money on everyone (roads, schools, pensions, soldiers). Fiscal policy is the deliberate use of those two levers — government spending and taxation — to steer the overall economy: to warm it up when it is sluggish, or to cool it down when it is overheating. It is one of the two main tools a country has to manage booms and busts; the other, run by the central bank, is monetary policy.

Concretely, fiscal policy has two settings. Expansionary fiscal policy means spending more, taxing less, or both — this puts extra money into people's hands and into the economy, boosting total demand. Suppose a recession hits and shops are empty; the government builds a railway and cuts income tax. The construction wages and the tax savings get spent, demand rises, and firms rehire. Contractionary fiscal policy is the reverse — spending less or taxing more — used to slow an overheating economy and tame inflation. The size of the effect depends on the fiscal multiplier: a dollar of government spending can raise total output by more or less than a dollar depending on how much of it gets re-spent.

Fiscal policy matters because it is the government's most direct way to fight recessions and to provide things markets undersupply. But it is contested. Critics warn that government borrowing can crowd out private investment, that politicians find it easy to spend and hard to cut, that the timing is often wrong (stimulus arrives after the slump has passed), and that some households may save a tax cut rather than spend it (the Ricardian equivalence idea). Honest economists disagree about how powerful fiscal policy really is — estimates of the multiplier vary widely depending on circumstances.