What is Fiscal Policy?

The policy that determines how much the government will spend and how much taxes the citizens have to pay is called the Fiscal Policy. These two things help the government proactively monitor and influence the economy of the country. The government uses Fiscal Policy either to curb recession and unemployment or to decrease inflation. Most of the time, Fiscal Policy is used in conjunction with Monetary Policy.

How Does Fiscal Policy Work?

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To understand how Fiscal policy works and what does fiscal policy do, let us consider two scenarios…

Scenario 1

Suppose, you don’t have a job now because there is no job opening. So you don’t buy too many things from your neighbourhood shopkeeper. As a result the income of the shopkeeper also dips. So, he, in turn, defers buying the smartphone that he has been eyeing. The smartphone manufacturer, because of the downturn, doesn’t hire any new employees. This is roughly what we see in a recession - low economic activity and high unemployment.

Recession and unemployment are bad - both from a citizen’s point of view and from the political point of view. So, the government tries to reverse this recessionary trend. How does it do that? It can two things (either or both) -

  • Increase government spending

  • Decrease taxes

So, how does increasing government spending decrease recession and unemployment? For that, you need to understand what government spending means. Government spending is those spending that it does to acquire goods and services for current or future use.

Now, let’s go back to the example mentioned above. Suppose the government starts spending a significant amount of money to build more hospitals, schools and to help the construction sector. As a result, new jobs will open up in these areas. So, now you can apply for a job in these sectors. When you get a job, you will start earning money. From your salary, you will spend a portion of your money to buy things from your neighbourhood shopkeeper. This will increase his income as well. As a result, he can now buy that smartphone. So the smartphone manufacturer will see an increase in activity and revenue. It will hire new employees to manage the extra workload. This chain-reaction is called the ripple effect in Economics. Thus, government spending boosts the entire nation’s economy.

Similarly, if the government reduces taxes, you will take home more percentage of your salary. So you can spend more. Again, if the taxes levied on the goods are lessened, their prices will come down too. The people will thus get encouraged to buy more goods.

Scenario 2

Now suppose, you and your friend both are working. You both need new earphones. Your neighbourhood shopkeeper has just one left. You both race against each other to grab the last earphone. What your shopkeeper does is - he decides to sell the earphone to the person who will pay more. Your friend offers Rs.200. But you offer Rs.300 and the shopkeeper agrees to give it to you. But just then a rich man arrives. The clever shopkeeper further increases the price of the earphone to Rs.500. The man pays the amount and walks away with the earphone. This is roughly how inflation works - your money can’t buy the same thing that it could buy yesterday - you need more money.

Here too, The Government Changes The Fiscal Policy to

  • Decrease government spending

  • Increase taxes

Decreasing government spending will create a contraction in job opportunities. As a result, people can become jobless or their salaries can decrease. On the other hand, an increase in taxes means the government will eat more from your salary. So you will take home less money. As a result, you will spend less. The demand for goods and services will come down. As a result, their prices will climb down too.

The History of Fiscal Policy

Now that you know what is meant by Fiscal Policy, let’s turn the pages of history. When you learn what is Fiscal Policy in Economics, you will come across a name - John Maynard Keynes. He was the one to come up with the idea of Fiscal Policy. Before Keynes, the earlier Economists believed that there should not be any government intervention in the Economic sphere of a nation. If the economy is seeing a downturn - it will correct itself in the long run. But the fallacy in their argument was that - in the intervening period before the correction happens, there could be thousands of job losses. The economy will be left in shambles.

Keynes says that there is no reason to wait and watch the destruction of the economy. The government can take proactive measures to curb the downturn and heal the economy. To understand more comprehensively what do you mean by Fiscal Policy, you also need to know the negative aspects of the Fiscal policy too which we have discussed in the FAQs section.

What Does Fiscal Policy Include?

The Fiscal Policy mainly includes two things:

  • Government Spending - Either increase or decrease.

  • Taxes - Either increase or decrease.

That’s all that is there in Fiscal Policy to understand what is the meaning of Fiscal Policy or what is Fiscal Policy Economics.

Did You Know?

India’s response to the economic downturn due to Covid19 is interesting. We see an overlapping of Fiscal and Monetary Policy. The AtmaNirbhar Package that the central government announced includes measures that will increase liquidity in the market (a product of monetary policy) and improve the job situation (a product of Fiscal Policy).

FAQs (Frequently Asked Questions)

1. What does Fiscal Policy mean? Or, what is Fiscal Policy definition?

Fiscal Policy is the policy that decides how much should a government spend and how much should the citizens pay in taxes. This policy is used to either reverse recession and unemployment or to decrease inflation.

2. What are the types of Fiscal Policy?

There are two types of Fiscal Policy-

  • Expansionary - When the government increases spending and decreases tax to create jobs and economic activity thereby reducing recession.

  • Contractionary - When the government does the opposite to reduce inflation.

3. What can be the criticism of Fiscal Policy?

According to Keynesian Policy or Fiscal Policy, when there is a recession the government needs to spend more money than what it collects as taxes. How? By borrowing. So the National Debt will increase. And this can cause significant problems in the future.