What is Fiscal Policy?

Fiscal policy is the use of government revenue collection (mainly taxes) and expenditure (spending) to influence the economy. According to Keynesian economics, when the government changes the levels of taxation and governments spending, it influences aggregate demand and the level of economic activity.

Fiscal policy can be used to stabilize the economy over the course of the business cycle. The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors. These changes can affect several macroeconomic variables and impact the economy to huge levels.

However, fiscal policy is quite unlike monetary policy. The former deals with taxation and government spending and is often administered by an executive under laws of a legislature, whereas monetary policy deals with the money supply, lending rates and interest rates and is often administered by a central bank.

Governments spend money on a wide variety of things, from the military and police to services like education and healthcare, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways, including taxation, by way of printing money, borrowings from the population or abroad, using fiscal reserves or by sale of fixed assets like land.

A fiscal deficit is often funded by issuing bonds, like treasury bills or gilt-edged securities against payment of interest. If the interest and capital requirements are too large, a nation may default on its debts, usually to foreign creditors. Public debt or borrowing refers to the government borrowing from the public.

The concept of a fiscal straitjacket is a general economic principle that suggests strict constraints on government spending and public sector borrowing, to limit or regulate the budget deficit over a time period.