Introduction to Fiscal Policy

When the recession of 2009 hit, the federal government tried to stimulate the American economy. It cut taxes and increased spending. In other words, it conducted expansionary fiscal policy.

Fiscal policy – the government’s policies on taxes, spending and borrowing – that’s used to try to mitigate fluctuations in the business cycle, to even out the booms and the busts. But, how is it that expansionary fiscal policy is capable of actually working?

Imagine an economy that’s operating at full employment. Workers have jobs, and factories are operating near capacity. If in that case, the federal government tries to increase spending to, say, build a new road, then it necessarily has to take away some people and some capital from other sectors of the economy. GDP wouldn’t increase, because there’s already full employment. So government spending would simply be crowding out private spending and investment. Building the new road? That may or may not be a good idea, depending on how valuable that road would be. But still, the increased government spending would not, in the short run, stimulate the economy.

But now, in contrast, imagine an economy during a recession. The fundamental factors of production are underused. Labor and capital are unemployed or underemployed. Machines and buildings are idle. In this case, government spending on a new road probably would increase GDP. In fact, an extra dollar spent during a recession might even increase GDP by more than a dollar. 

Say, for instance, the government hires unemployed construction workers. These construction workers then use their new income to, say, eat out at restaurants. This causes restaurant owners to hire more workers, and these newly-employed waiters and waitresses – they then spend their money throughout the economy. There’s a kind of ripple effect, and the people who receive that money in turn spend more money themselves.

The subsequent increases in spending caused by the initial increase in government spending – that’s known as the “fiscal multiplier.”

Now, expansionary fiscal policy is not the only kind of fiscal policy. The government also conducts contractionary fiscal policy by saving during an economic boom – by either increasing taxes or by decreasing spending. At least, that’s how fiscal policy is supposed to work. 

Later, we’ll discuss some of the political economy issues of continual deficit spending and why government surpluses sometimes are so hard to come by.

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