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Fiscal policy explained

What is fiscal policy?

Fiscal policy is set by the government which outlines the plan for borrowing and spending and taxes. Through fiscal policy, the government aims to influence economic conditions by increasing or decreasing demand for goods and services.

Understanding fiscal policy

Government intervention through public fiscal policy was introduced from an economic theory called Keynes’s theory.

British economist, John Maynard Keynes, led a revolutionary change in economic thinking which was contrary to the idea that free market economies could self-function and recover from downturns without government intervention. This theory was discovered during the Great Depression in the 1930s, at a time where economists were finding it difficult to explain such a lengthy economic collapse.

The main part of Keynes’s theory suggests aggregate demand – which is measured by the total spending by households, businesses, and the government – is the centerpiece to a thriving economy. Keynes argued a lack of aggregate demand during a recession leads to long periods of unemployment as economies find it difficult to stabilise self-sufficiently.

In an economic downturn consumers and businesses tend to tighten the purse strings. Consumer confidence is dampened by the uncertainty, so they tend to spend less on discretionary items such as a new home or car. This has a knock-on effect to businesses who invest less into new opportunities as there’s weakened demand for their good and services.

According to Keynesian economics, this is where government intervention is essential to kick start demand in the economy through fiscal stimulus and offer stability during the booms and busts of the business cycle. The furlough scheme is an example of fiscal stimulus which was introduced during the COVID-19 pandemic.

Expansionary fiscal vs contractionary fiscal policy

Expansionary fiscal policy is where the government intends to increase the overall demand for goods and services in the economy and spur further economic growth.

If there are signs that the economy is slowing to a crawl, or perhaps into a recession, the government could look to lower taxes. Paying less in tax means more money in people’s pockets so consumers and businesses are happy to spend more. This increases overall demand for goods and services.

Contractionary fiscal policy is the opposite. This type of policy is implemented by governments when they want to reduce demand. Governments could look to adopt this approach if inflation, the price for goods and services, is running above the government’s 2% target. In this scenario, higher taxes mean people have less money to splash out on goods and services.

Fiscal policy vs monetary policy

Fiscal and monetary policy are both tools to influence the economy and are similar in terms of their aim of achieving positive economic growth and keeping inflation low.

However, there are some key differences.

Monetary policy vs Fiscal policy

Monetary policy Fiscal policy
Interest rates and money supply Government spending and taxes
Set by a central bank Set by the government
Impacts exchange rates and bond yields Impacts government deficit/surplus and borrowing
Independent from political intervention Strong link to political policies
Inflation target No inflation target

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