Using Fiscal Policy to Manage the Economy

Using Fiscal Policy to Manage the Economy

Fiscal policy is taxing and spending by the government. At the federal level, it is primarily conducted by the U.S. Congress. The annual budget is proposed by the President, however, who has veto power over legislation. Fiscal policy can be used as a tool to manage the economy, but it has a large political bias.

Aggregate demand (AD), which is overall spending on newly produced goods and services, is composed of consumption (C), investment (I), government purchases (G), and net exports (X-M). Thus AD = C + I + G + X – M. Expansionary fiscal policy attempts to stimulate the economy by increasing overall spending on newly produced goods and services through (1) increased government purchases (G), or (2) decreased taxes to encourage more consumption (C) and investment (I) spending. Expansionary fiscal policy can be used to fight unemployment. It also promotes economic growth if it generates investment in physical capital, human capital, and technology, which tend to increase productivity.

Contractionary fiscal policy attempts to slow the economy by decreasing overall spending on newly produced goods and services through (1) decreased government purchases, or (2) increased taxes to discourage consumption and investment spending. Contractionary fiscal policy can be used to fight inflation.

Fiscal policy’s political bias is that politicians are reluctant to conduct contractionary fiscal policy because increasing taxes and reducing government spending on constituents are politically unpopular. Using fiscal policy to manage the economy is similar to driving a car with an accelerator pedal, but no brakes.