Fiscal policy, also known as financial policy, is the method by which governments adjust their levels of spending and taxation to influence the economy directly. Fiscal policy is closely linked with monetary policy (the influence of central banks on the money supply) to achieve various economic objectives.
The financial policy gained popularity during the 1930s after British economist John Maynard Keynes had advocated it. He suggested that whenever a nation is in recession, increasing the amount of money in the hands of consumers could lead to economic growth. This could be done by reducing taxes or increasing government spending.
Various Fiscal Policies
The following are the three basic financial policies: neutral, expansionary, and contractionary.
Neutral – Government spending is roughly equal to its revenue.
Expansionary – Government spending exceeds its revenue.
Contractionary – Government spending is lower than its revenue.
Effects of Fiscal Policies on Exchange Rates
The effect of fiscal policy on the currency is highly dependent on the state of the economy. Since each country is unique and the economic environment is constantly evolving, it is challenging to predict precisely how fiscal policy will impact exchange rates.
Let’s say a government has a budget deficit due to an expansionary fiscal policy. To finance the deficit, the government can work with the central bank to print fresh currency (also known as quantitative easing).
The government can use the newly printed money in its economic development projects. The increase in money supply can end up being inflationary and lead to a weakening of the value of the domestic currency against foreign currencies.
Fiscal Policy vs. Monetary Policy
The government handles fiscal policy. It refers to the use of taxes and the government’s spending to either boost or slow down the economy.
The U.S. Federal Reserve Board manages monetary policy. This is about controlling the amount of money available in the country. The goal is to maintain high employment levels, stable prices, and reasonable interest rates, as instructed by Congress.
The Federal Reserve uses different tools to control the amount of money in circulation and how much people spend and borrow:
- Buying or selling securities on the open market
- Lending money to banks through its discount window
- Setting the discount rate
- Setting the federal funds rate
- Deciding how much money banks must keep in reserve
- Swapping money with other central banks
- Using overnight agreements for repurchasing assets.
FAQs
Who Handles Fiscal Policy?
In the United States, fiscal policy is managed by the government. The President and the Secretary of the Treasury in the executive branch play big roles in making financial decisions. Sometimes, the President also gets advice from a group called the Council of Economic Advisers.
In the legislative branch, specifically Congress, they make decisions about taxes and spending. Congress has two parts: the House of Representatives and the Senate. They work together to discuss and approve fiscal policies.
What Are the Main Tools of Fiscal Policy?
Governments use fiscal policy tools to affect the economy. These tools mainly involve changing taxes and government spending. When they want to boost growth, they lower taxes and increase spending. Sometimes, they have to borrow money by selling government bonds to do this. When the economy gets too hot, they may raise taxes and cut spending to slow things down.
How Does Fiscal Policy Affect People?
Sometimes, changes in how the government handles money don’t impact everyone the same way. It depends on what the people making the decisions want to achieve. For instance, if there is a tax reduction, it might primarily benefit the middle class, which is often the largest group of earners. However, if the economy is struggling and taxes are increasing, the middle class may end up paying more than the wealthy.
Likewise, when the government decides to allocate funds differently, it affects various groups. For example, if they choose to build a new bridge, it creates jobs and generates additional income for many construction workers. However, if they decide to invest in a new space shuttle, it will only benefit a small group of experts and companies. This wouldn’t significantly improve overall job opportunities.
Should the Government Get Involved in the Economy?
Deciding how much the government should be involved in the economy and how people’s money is managed is a significant challenge for policymakers. Throughout the history of the United States, the government has been involved in different ways. Generally, people agree that some level of government involvement is necessary to maintain a strong economy and support the financial well-being of the population.