Fiscal policy is how Congress and other elected officials influence the economy using spending and taxation. It is used in conjunction with the monetary policy implemented by central banks. It influences the economy using the money supply and interest rates.

The objective of fiscal policy is to create healthy economic growth. Ideally, the economy should grow between 2 to 3 percent a year. Unemployment will be at its natural rate of between 4.7 and 5.8 percent. Inflation will be at its target rate of 2 percent. The business cycle will be in the expansion phase.

Types
There are two types of fiscal policy. The most widely-used is expansionary. It stimulates economic growth. Congress uses it to end the contraction phase of the business cycle. That’s when voters are clamoring for relief from a recession.

How does it work? The government either spends more, cuts taxes, or both. The idea is to put more money into consumers’ hands, so they spend more. The increased demand forces businesses to add jobs to increase supply.

Politicians debate about which works better. Advocates of supply-side economics prefer tax cuts. They say it frees up businesses to hire more workers to pursue business ventures. Advocates of demand-side economics say additional spending is more effective than tax cuts. Examples include public works projects, unemployment benefits, and food stamps. The money goes into the pockets of consumers, who go right out and buy the things businesses produce

The Balance
Fiscal Policy Types, Objectives, and Tools

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Fiscal policy is how Congress and other elected officials influence the economy using spending and taxation. It is used in conjunction with the monetary policy implemented by central banks. It influences the economy using the money supply and interest rates.

The objective of fiscal policy is to create healthy economic growth. Ideally, the economy should grow between 2 to 3 percent a year. Unemployment will be at its natural rate of between 4.7 and 5.8 percent. Inflation will be at its target rate of 2 percent. The business cycle will be in the expansion phase.

Types
There are two types of fiscal policy. The most widely-used is expansionary. It stimulates economic growth. Congress uses it to end the contraction phase of the business cycle. That’s when voters are clamoring for relief from a recession.

How does it work? The government either spends more, cuts taxes, or both. The idea is to put more money into consumers’ hands, so they spend more. The increased demand forces businesses to add jobs to increase supply.

Politicians debate about which works better. Advocates of supply-side economics prefer tax cuts. They say it frees up businesses to hire more workers to pursue business ventures. Advocates of demand-side economics say additional spending is more effective than tax cuts. Examples include public works projects, unemployment benefits, and food stamps. The money goes into the pockets of consumers, who go right out and buy the things businesses produce.

An expansionary fiscal policy is impossible for state and local government. They are mandated to keep a balanced budget. If they haven’t created a surplus during the boom times, they must cut spending to match lower tax revenue during a recession. That makes the contraction worse.

Fortunately, the federal government has no such constraints. It’s free to use expansionary policy whenever it’s needed. Unfortunately, it also means Congress created budget deficits even during economic booms. That’s despite a national debt ceiling. As a result, the critical debt-to-gross domestic product ratio has exceeded 100 percent.

The second type of fiscal policy is contractionary fiscal policy. It’s rarely used. Its goal is to slow economic growth. Why would you ever want to do that? One reason only. That’s to stamp out inflation. The long-term impact of inflation can damage the standard of living as much as a recession.
of Medicare, Medicaid, and Social Security are rising. Changing the mandatory budget requires an Act of Congress and that takes a long time. One exception was the American Recovery and Economic Stimulus Act. Congress passed it quickly to stop the Great Recession.

Fiscal Policy versus Monetary Policy
Monetary policy is the process by which a nation changes the money supply. The country’s monetary authority increases it with expansionary monetary policy and decreases it with contractionary monetary policy. It has many tools it can use, but it primarily relies on raising or lowering the fed funds rate. This benchmark rates then guides all others. 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 faster than fiscal policy. The Fed votes to raise or lower rates at its regular Federal Open Market Committee meeting. It may take about six months for the impact of the rate cut to percolate throughout the economy.

Lawmakers should coordinate fiscal policy with monetary policy. They don’t. Why? Their fiscal policy reflects the priorities of individual lawmakers. They focus on the needs of their constituencies. These local needs often overrule national economic priorities. As a result, often fiscal policy runs counter to what the economy needs. Central banks are forced to use monetary policy to offset poorly planned fiscal policy.

Current Budget Spending
Congress outlines U.S. fiscal policy priorities in each year’s federal budget. By far, the largest portion of budget spending is mandatory, which means that existing laws dictate how much will be spent. Most of this is for Social Security, Medicare, and Medicaid entitlement programs.