In order to secure financing for its expenditures, the government relies on two methods: taxation and borrowing. Taxation takes many forms in developed countries, including taxes on personal and corporate income, so-called value-added taxation, and the collection of royalties or taxes on specific sets of goods.
This effectively meant the Fed ended up financing the entire deficit and bidding up the price of the existing float of T-Bonds. Quantitative Easing was designed to lower long-term interest rates and to encourage economic activity, so it is a form of both monetary and fiscal policy. In summary, the definition of fiscal policy is the taxation, finance and spending programs that governments use to affect the economy.
Governments in democratic societies have many different and conflicting objectives, all of which affect their fiscal policies. They may use fiscal policy to moderate the down phase of the business and economic cycle by seeking to maintain employment and boost economic growth.
They also may use fiscal policy to improve the living standards of their citizens for political or social reasons. The definition of fiscal policy is complicated but it is a very important concept to understand. Fiscal policy has a huge impact on the overall environment in which people work and invest so it is very important to Joe and Suzy Q Public.
A fiscal policy definition is an important aspect of government spending. Here you can find a brief description of how such a definition is used. Methods of Taxation and Fiscal Policy In order to secure financing for its expenditures, the government relies on two methods: taxation and borrowing. By using a mix of monetary and fiscal policies depending on the political orientations and the philosophies of those in power at a particular time, one policy may dominate over another , governments can control economic phenomena.
Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics , this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending.
Fiscal policy plays a very important role in managing a country's economy. For example, in many worried that the fiscal cliff , a simultaneous increase in tax rates and cuts in government spending set to occur in January , would send the U.
The U. The idea is to find a balance between tax rates and public spending. For example, stimulating a stagnant economy by increasing spending or lowering taxes, also known as expansionary fiscal policy, runs the risk of causing inflation to rise. This is because an increase in the amount of money in the economy, followed by an increase in consumer demand, can result in a decrease in the value of money—meaning that it would take more money to buy something that has not changed in value.
Let's say that an economy has slowed down. Unemployment levels are up, consumer spending is down, and businesses are not making substantial profits. A government may decide to fuel the economy's engine by decreasing taxation, which gives consumers more spending money while increasing government spending in the form of buying services from the market such as building roads or schools. By paying for such services, the government creates jobs and wages that are in turn pumped into the economy.
Pumping money into the economy by decreasing taxation and increasing government spending is also known as " pump priming. With more money in the economy and less taxes to pay, consumer demand for goods and services increases.
This, in turn, rekindles businesses and turns the cycle around from stagnant to active. If, however, there are no reins on this process, the increase in economic productivity can cross over a very fine line and lead to too much money in the market. This excess in supply decreases the value of money while pushing up prices because of the increase in demand for consumer products.
Hence, inflation exceeds the reasonable level. For this reason, fine-tuning the economy through fiscal policy alone can be a difficult, if not improbable, means to reach economic goals.
If not closely monitored, the line between a productive economy and one that is infected by inflation can be easily blurred. When inflation is too strong, the economy may need a slowdown. In such a situation, a government can use fiscal policy to increase taxes to suck money out of the economy. Fiscal policy could also dictate a decrease in government spending and thereby decrease the money in circulation.
Of course, the possible negative effects of such a policy, in the long run, could be a sluggish economy and high unemployment levels. Nonetheless, the process continues as the government uses its fiscal policy to fine-tune spending and taxation levels, with the goal of evening out the business cycles. Unfortunately, the effects of any fiscal policy are not the same for everyone. Depending on the political orientations and goals of the policymakers, a tax cut could affect only the middle class, which is typically the largest economic group.
In times of economic decline and rising taxation, it is this same group that may have to pay more taxes than the wealthier upper class. Similarly, when a government decides to adjust its spending, its policy may affect only a specific group of people. A decision to build a new bridge, for example, will give work and more income to hundreds of construction workers.
Expansionary fiscal policy involves the measures taken by the government to put more money back into the economy. This generally creates demand for products and services.
It creates jobs and increases profits—stimulating economic growth. Congress uses it to slow the contraction phase of the business cycle—usually called a "recession. The idea is to put more money into consumers' hands to induce them to spend more. The increased demand forces businesses to add jobs to increase supply, output, and consumer spending. The second type of fiscal policy is contractionary, used during economic booms. Since expansions can also be dangerous for an economy, the government tries to slow them down they become too intense.
Too much growth can fuel investor exuberance and overconfidence as well as greed , creating market bubbles or other unforeseen economic dangers.
Contractionary fiscal policies are enacted to try to slow growth to a more manageable level and control inflation. The government begins collecting more taxes and reduces spending to keep investment prices down and to raise the unemployment rate. The economy needs a certain amount of unemployed workers for businesses to hire—if companies can't find workers, production growth slows down. The U. This means the government uses contractionary fiscal policies more than it does expansionary fiscal policies.
Monetary policy differs from fiscal policy in that decisions are made to change the U. S dollar's purchasing power, and interest rates are managed to influence the economy.
The Federal Open Market Committee FOMC creates changes that increase or decrease the supply of money or the federal funds rate—the interest rate that influences all others.
The Federal Reserve the Fed has several tools to increase and decrease interest rates or the dollar value. These two tools are used at the same time to influence the federal funds rate. When interest rates are high, the money supply contracts, the economy cools down, and inflation is prevented. When interest rates are low, the money supply expands, the economy heats up, and a recession is usually avoided. Monetary policy works more quickly than fiscal policy.
The Federal Open Market Committee meets eight times per year and votes to raise or lower rates. However, it can take up to six months for rate changes to impact the economy. Until the Great Depression, most fiscal policies followed the laissez-faire economic theory. Politicians believed they shouldn't interfere with capitalism in a free market economy, but Franklin D. Roosevelt's plans implemented expansionary fiscal policies by spending to build roads, bridges, and dams.
The federal government hired millions of workers for these projects. In the economy grew by It increased by 8. To slow the growth, FDR implemented contractionary fiscal policies, which cut government spending. By , the economy had decreased by 3.
The depression might have ended, but unemployment was still high during the s with many people looking for work after war-time production had begun to shut down. Congress passed the Employment Act of to give the government the ability to enact policies to keep employment and production high. Fiscal policies generally take the form of funding from the government to accomplish policy objectives.
The Humphrey-Hawkins Act was expansionary. It also tried to use federal assistance to expand private and public employment while building stockpiles of materials and commodities in an attempt to fuel growth. President George W. The intent behind these two laws was to cut taxes to stimulate economic growth. However, the tax cuts truly only benefitted the top one-fifth of households and created mediocre growth at best.
The coronavirus impacted the U. To stabilize financial markets and provide backstop liquidity, the Federal Reserve implemented a massive monetary easing program.
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