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In economics and political science, fiscal policy is the use of government revenue collection (mainly taxes) and expenditure (spending) to monitor and influence a nation's economy. It developed out of the Great Depression, when the laissez-faire approach to economic management was ended and government intervention became the means of influencing macroeconomic variables. Fiscal and monetary policy are two sister strategies that are used by the government and the central bank in order to reach a county's economic objectives. The theories of the British economist John Maynard Keynes are the basis for fiscal policy. According to Keynesian economics, when the government changes the levels of taxation and government spending, it influences aggregate demand and the level of economic activity. This influence enables the fiscal authority to target the inflation (which is considered "healthy" at the level in the range 2%–3%) and to increase employment. Additionally, it is designed to try to keep GDP growth at 2%–3% and the unemployment rate near the natural unemployment rate of 4%–5%.[1] This implies that fiscal policy is used to stabilize the economy over the course of the business cycle.[2]

Changes in the level and composition of taxation and government spending can affect the following macroeconomic variables, among others:

Fiscal policy can be distinguished from monetary policy, in that fiscal policy deals with taxation and government spending and is often administered by an executive under laws of a legislature. Monetary policy, on the other hand, deals with the money supply and interest rates and is often administered by a central bank (the Federal Reserve Bank in the US and the Bank of England in the UK). It sets the base interest rate (the federal funds rate in the US) and also affects the supply of money (for example, using quantitative easing policy to increase the money supply). Both fiscal and monetary policies can be used in order to influence the economic performance in the short run.

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  • ✪ Monetary and Fiscal Policy: Crash Course Government and Politics #48
  • ✪ Fiscal & Monetary Policy Review- AP Macroeconomics
  • ✪ Fiscal Policy Part 1.mp4
  • ✪ Fiscal Policy and Crowding Out
  • ✪ Fiscal Policy


Hello, I’m Craig and this is Crash Course Government and Politics and today we’re finally gonna talk about a topic I know that you've all been waiting for: Monetary and Fiscal policy. Hurray! You haven’t been waiting for monetary and fiscal policy? Are you sure? I’ve been talking it up for weeks, you know? Well, let me see if I can’t convince you to be as excited as I am. Monetary Policy! Wooo! Fiscal Policy! Yeah! I want to get fiscal, fiscal. Come on and get fiscal… okay let’s start the show. [Theme Music] Let’s start with monetary policy because it’s not at all controversial. Well, it kind of is controversial, but it’s less contentious than fiscal policy. Monetary policy is basically the way the government regulates the amount of money in circulation in the nation’s economy. Controlling the money supply is the primary task of the Federal Reserve System and since it’s a little bit complicated, I’m going to talk about the other things that the Fed does first. The Federal Reserve System was created in 1913 to serve as America’s central bank. Before then, there were state and local banks as well as a Bank of the United States, which was a much more limited central bank. The Fed is made up of 12 regional banks, and two boards. The Federal Reserve Board of Governors, who are appointed by the President, and the Federal Open Market Committee, which is partially appointed by the president. The Fed has two primary tasks: to control inflation and to encourage full employment, and it has four basic functions, but one of them is way more important than the others. The Fed is responsible, ultimately for clearing checks, and for supplying actual currency, most of which is kept in highly secure facilities staffed by robots. With laser eyes. I don’t know if they have laser eyes. The Fed also sets up rules for banks, although these can also be set by Congress. But the most important thing that the Fed does is loan money to other banks and set interest rates. That’s why when you hear about the Federal Reserve, nine times out of ten it’s about interest rates, because that’s the main way the Fed controls the money supply. The Fed loans money to banks, sweet, sweet money, which they in turn loan out to businesses and individuals and, like all loans, the Fed charges interest. The Fed sets the rate on the interest, called the discount rate, and this determines, mostly, how much money banks will borrow. The lower the rate, the more banks will borrow and the more money goes into circulation. Other banks peg the interest rates they charge to the Fed’s rate, charging slightly more, so in this way the Fed determines, or sets, interest rates in the economy as a whole. The Fed also creates regulations that control how much money circulates in the economy. One of these is the bank reserve requirement, or the amount of money in cash that a bank has to have on hand. Now the amount of money that a bank holds in reserve is only a fraction of the total amount of money held in deposit at the bank – that’s why it’s called fractional reserve banking – but the reserve requirement is there so that you don’t get catastrophic bank runs like we saw during the Great Depression when so many frightened depositors took their money out of banks that the banks failed. Raising the reserve requirement reduces the amount of money in circulation and lowering it pumps more money into the economy. The Federal Reserve also sets the interest rate banks charge to lend money to each other, which again controls the amount of money that circulates. If banks are charging each other a lot of money to borrow, they won’t borrow as much, and they won’t lend as much to firms and individuals and there will be less money in the economy as a whole. There’s at least one more important way that the Fed influences the money supply in the U.S. and that’s through Open Market Operations. This is a fancy way to say that the Fed buys and sells government debt in the form of treasury bills, or government bonds. When the Fed sells bonds, it takes money out of the economy, and when it buys them more money goes into the economy. This is the idea behind what was known as Quantitative Easing, which is really complicated. To be honest, I’m not crazy about wading into economics here, and thankfully there’s a whole other series to do that, but I have to mention inflation at this point. Inflation is a general rise in prices that can be caused by a number of things, but one of them is the amount of money that circulates. If there’s more money around, there’s more that can be spent and this makes it possible for prices to go up. But this isn’t an absolute rule, as of 2016 we’ve had years of basically zero interest rates, which means it’s really cheap to borrow money, which means that there should be a lot of money in circulation, yet inflation remains quite low. Hey, it’s real cheap to borrow money. Can I borrow two bucks? No! [punches eagle] He never has any money. Usually low interest rates tend to cause inflation and reduce unemployment, and high interest rates are expected to cool down an overheating economy, but that hasn’t happened much in the past few years. I’ll say again, I glad this isn’t an economic series. It’s important to note here that the Federal reserve is an independent body, meaning that its board of governors and chairperson are not elected or really subject to much regulation from Congress. And they throw the best parties. That’s probably why. This is intentional and probably a good idea. Ideally, you want people in charge of the money supply to be able to look after broader interests than their own re-election, and this is why the Fed is supposed to be insulated from politics and remain independent. Ok, so that’s monetary policy, which is one lever that the federal government can use to influence the economy. Increasingly it’s the only lever, because in America we have a hard time with fiscal policy. What’s that, you might be asking? Fiscal policy refers to the government’s ability to raise taxes and spend the money it raises. Since I know that by this episode you’ve been paying a lot of attention to American politics, you know that in the past 20 or 30 years, at least, Americans have generally been reluctant to raise taxes, and somewhat reluctant to have the government spend money. The difference between these two goals – spending money and not raising taxes – largely explains why we have deficits. Before we get into tax policy, which I know is what you’ve been waiting for, calm down, I need to point out that the way the government can spend more money on programs than it takes in taxes is by borrowing it, which the government does by, you guessed it, selling bonds. Good thing we talked about Open Market Operations. Let’s tax the Thought Cafe people with a lot of work, by talking about taxes and spending in the Thought Bubble. First, ever since Ronald Reagan came to office there has been a hostility towards higher taxes and government spending that is theoretically based in an idea called supply side economics. I’m not going to discuss the details of the theory or even whether it’s right or wrong or somewhere in between, but the basic thrust is that if you lower taxes on businesses and individuals, the individuals will be able to spend more, the businesses will be able to invest more, and the economy as a whole will grow. It’s a simple and politically powerful idea and has set the terms of the debate for a generation. In general, over the past 30 years the trend is for there to be lower federal taxes and for them to be less progressive, meaning that wealthier people pay a lower percentage of their income in Federal taxes. The wealthy still pay the largest share of federal taxes overall, though, so it’s not completely accurate to say that they aren’t paying. Since Reagan, and especially during the presidency of George W. Bush, income tax rates on the highest earners have fallen, as have taxes on estates (although they did go up again) and on capital gains and dividends. President Obama did raise tax rates, but primarily on people earning above $450,000 a year. Corporate tax rates have also declined and Social Security taxes have gone up, which is important because this is the federal tax that most of us are most likely to pay. Overall the percentage of revenue that the federal government receives from taxes has held pretty steady at between 43% and 50%. If you’re interested in the numbers, for 2013 the government received almost $2.8 trillion in tax revenues. And it spent $3.5 trillion, which math tells us means a deficit of around 700 billion dollars. Thanks, Thought Bubble. When people say that they need to cut spending and balance the budget, this is what they are talking about, but it’s not quite as simple as just spending less, because there are some places where the government can’t cut spending even if they want to. There are certain items in the federal budget that must be spent because they are written into law by Congress. These are called uncontrollables, or mandatory spending. One uncontrollable that relates to monetary policy is interest payments on federal debt. The government can’t not pay its interest, otherwise no one would lend us money. That's just how lending works, or it's supposed to work. Farm price supports – subsidies – are also counted as uncontrollables, and they are important, but not nearly as important as the two big-ticket mandatory spending items. These are social security and Medicare, and they are paid for with dedicated federal taxes. They provide income and health insurance for elderly people and it’s unlikely that the amounts the government spends on them is going to decline anytime soon for three reasons. First, is that the population is aging, meaning that the percentage of older Americans is rising in proportion to younger Americans. This means that more people will be receiving Social Security payments, which leads us to the second reason they are unlikely to go down: people like them. The third reason is more political: older people tend to vote more regularly, so a politician who wants to keep their job is unlikely to vote for cuts in Social Security or Medicare. So, here’s the thing about the Federal Reserve and economics: The American economy is really huge, and really complicated, and has some issues that need addressing. Whether you care a lot about budget deficits or don’t think they're a big deal will depend a lot on your feelings about economics in general, but there are a couple of things to keep in mind. First, there's only a limited range of programs on which the government can choose to spend or not spend. These are called discretionary spending and when people call for cuts in government spending, this is what they mean. By far the largest chunk of government spending goes into defense, over $600 billion in 2013, but the next largest item is healthcare for the poor, Medicaid, at $498 Billion. Nothing else even comes close. Spending on the Department of Education, for example, was $41 billion in 2013. The second thing to bear in mind is that in addition to cutting spending, the government could balance its budget by doing what everyone loves - raising taxes. It's done this on occasion, but the political consequences can be pretty tough. Just ask George H.W. Bush. Finally, the combination of Americans’ aversion to raising taxes and the government’s limited ability to cut spending means that monetary policy becomes its major lever in broad-based macroeconomic policy. That’s why we paid so much attention to the Federal Reserve system at the beginning of this episode, and why you probably should too. Thanks for watching. See you next time. Crash Course Government and Politics is produced in association with PBS Digital Studios. Support for Crash Course: U.S. Government comes from Voqal. Voqal supports nonprofits that use technology and media to advance social equity. Learn more about their mission and initiatives at Crash Course was made with the help of all these broad based macroeconomic policy makers. Thanks for watching.


Monetary or fiscal policy?

Since the 1970s, it became clear that monetary policy performance has some benefits over fiscal policy due to the fact that it reduces political influence, as it is set by the central bank (to have a booming economy before the general election, politicians might cut the interest rates). Additionally, fiscal policy can potentially have more supply-side effects on the economy: to reduce inflation, the measures of increasing taxes and lowering spending would not be preferred, so the government might be reluctant to use these. Monetary policy is generally quicker to implement as interest rates can be set every month, while the decision to increase government spending might take time to figure out which area the money should be spent on.[3]

The recession of the 2000s decade shows that monetary policy also has certain limitations. A liquidity trap occurs when interest rate cuts are insufficient as a demand booster as banks do not want to lend and the consumers are reluctant to increase spending due to negative expectations for the economy. Government spending is responsible for creating the demand in the economy and can provide a kick-start to get the economy out of the recession. When a deep recession takes place, it is not sufficient to rely just on monetary policy to restore the economic equilibrium.[3] Each side of these two policies has its differences, therefore, combining aspects of both policies to deal with economic problems has become a solution that is now used by the US. These policies have limited effects; however, fiscal policy seems to have a greater effect over the long-run period, while monetary policy tends to have a short-run success.[4]


Depending on the state of the economy, fiscal policy may reach for different objectives: its focus can be to restrict economic growth by mediating inflation or, in turn, increase economic growth by decreasing taxes, encouraging spending on different projects that act as stimuli to economic growth and enabling borrowing and spending. The three stances of fiscal policy are the following:

  • Neutral fiscal policy is usually undertaken when an economy is in neither a recession nor a boom. The amount of government deficit spending (the excess not financed by tax revenue) is roughly the same as it has been on average over time, so no changes to it are occurring that would have an effect on the level of economic activity.
  • Expansionary fiscal policy is used by the government when trying to balance the contraction phase in the business cycle. It involves government spending exceeding tax revenue by more than it has tended to, and is usually undertaken during recessions. Examples of expansionary fiscal policy measures include increased government spending on public works (e.g., building schools) and providing the residents of the economy with tax cuts to increase their purchasing power (in order to fix a decrease in the demand).
  • Contractionary fiscal policy, on the other hand, is a measure to increase tax rates and decrease government spending. It occurs when government deficit spending is lower than usual. This has the potential to slow economic growth if inflation, which was caused by a significant increase in aggregate demand and the supply of money, is excessive. By reducing the economy's amount of aggregate income, the available amount for consumers to spend is also reduced. So, contractionary fiscal policy measures are employed when unsustainable growth takes place, leading to inflation, high prices of investment, recession and unemployment above the "healthy" level of 3%–4%.

However, these definitions can be misleading because, even with no changes in spending or tax laws at all, cyclic fluctuations of the economy cause cyclic fluctuations of tax revenues and of some types of government spending, altering the deficit situation; these are not considered to be policy changes. Therefore, for purposes of the above definitions, "government spending" and "tax revenue" are normally replaced by "cyclically adjusted government spending" and "cyclically adjusted tax revenue". Thus, for example, a government budget that is balanced over the course of the business cycle is considered to represent a neutral and effective fiscal policy stance.

Methods of fiscal policy funding

Governments spend money on a wide variety of things, from the military and police to services such as education and health care, as well as transfer payments such as welfare benefits. This expenditure can be funded in a number of different ways:


A fiscal deficit is often funded by issuing bonds, such as Treasury bills or consols and gilt-edged securities. These pay interest, either for a fixed period or indefinitely. 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.

Dipping into prior surpluses

A fiscal surplus is often saved for future use, and may be invested in either local currency or any financial instrument that may be traded later once resources are needed and the additional debt is not needed.

Fiscal straitjacket

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. Most US states have balanced budget rules that prevent them from running a deficit. The United States federal government technically has a legal cap on the total amount of money it can borrow, but it is not a meaningful constraint because the cap can be raised as easily as spending can be authorized, and the cap is almost always raised before the debt gets that high.

Economic effects

Governments use fiscal policy to influence the level of aggregate demand in the economy, so that certain economic goals can be achieved:

  • Price stability;
  • Full employment;
  • Economic growth.

The Keynesian view of economics suggests that increasing government spending and decreasing the rate of taxes are the best ways to have an influence an aggregate demand, stimulate it, while decreasing spending and increasing taxes after the economic boom has already taken place. Additionally, Keynesians argue that expansionary fiscal policy should be used in times of recession or low economic activity as an essential tool for building the framework for strong economic growth and working towards full employment. In theory, the resulting deficits would be paid for by an expanded economy during the boom that would follow; this was the reasoning behind the New Deal.

Governments can use a budget surplus to do two things:

  • to slow the pace of strong economic growth;
  • to stabilize prices when inflation is too high.

Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices.

But economists still debate the effectiveness of fiscal stimulus. The argument mostly centers on crowding out: whether government borrowing leads to higher interest rates that may offset the stimulative impact of spending. When the government runs a budget deficit, funds will need to come from public borrowing (the issue of government bonds), overseas borrowing, or monetizing the debt. When governments fund a deficit with the issuing of government bonds, interest rates can increase across the market, because government borrowing creates higher demand for credit in the financial markets. This decreases aggregate demand for goods and services, either partially or entirely offsetting the direct expansionary impact of the deficit spending, thus diminishing or eliminating the achievement of the objective of a fiscal stimulus. Neoclassical economists generally emphasize crowding out while Keynesians argue that fiscal policy can still be effective, especially in a liquidity trap where, they argue, crowding out is minimal.[5]

In the classical view, expansionary fiscal policy also decreases net exports, which has a mitigating effect on national output and income. When government borrowing increases interest rates it attracts foreign capital from foreign investors. This is because, all other things being equal, the bonds issued from a country executing expansionary fiscal policy now offer a higher rate of return. In other words, companies wanting to finance projects must compete with their government for capital so they offer higher rates of return. To purchase bonds originating from a certain country, foreign investors must obtain that country's currency. Therefore, when foreign capital flows into the country undergoing fiscal expansion, demand for that country's currency increases. The increased demand, in turn, causes the currency to appreciate, reducing the cost of imports and making exports from that country more expensive to foreigners. Consequently, exports decrease and imports increase, reducing demand from net exports.

Some economists oppose the discretionary use of fiscal stimulus because of the inside lag (the time lag involved in implementing it), which is almost inevitably long because of the substantial legislative effort involved. Further, the outside lag between the time of implementation and the time that most of the effects of the stimulus are felt could mean that the stimulus hits an already-recovering economy and exacerbates the ensuing boom rather than stimulating the economy when it needs it.

Some economists are concerned about potential inflationary effects driven by increased demand engendered by a fiscal stimulus. In theory, fiscal stimulus does not cause inflation when it uses resources that would have otherwise been idle. For instance, if a fiscal stimulus employs a worker who otherwise would have been unemployed, there is no inflationary effect; however, if the stimulus employs a worker who otherwise would have had a job, the stimulus is increasing labor demand while labor supply remains fixed, leading to wage inflation and therefore price inflation.

See also


  1. ^ Kramer, Leslie. "What Is Fiscal Policy?". Investopedia. Dotdash. Retrieved April 26, 2019.
  2. ^ O'Sullivan, Arthur; Sheffrin, Steven M. (2003). Economics: Principles in Action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. p. 387. ISBN 978-0-13-063085-8.
  3. ^ a b Pettinger, Tejvan. "Difference between monetary and fiscal policy". Retrieved April 26, 2019.
  4. ^ Schmidt, Michael. "A Look at Fiscal and Monetary Policy". Invetopedia. Dotdash. Retrieved April 26, 2019.
  5. ^ "Cliff Notes, Economic Effecs of Fiscal Policy". Retrieved March 20, 2013.


  • Simonsen, M.H. The Econometrics and The State Brasilia University Editor, 1960–1964.
  • Heyne, P. T., Boettke, P. J., Prychitko, D. L. (2002). The Economic Way of Thinking (10th ed). Prentice Hall.
  • Larch, M. and J. Nogueira Martins (2009). Fiscal Policy Making in the European Union: An Assessment of Current Practice and Challenges. Routledge.
  • Hansen, Bent (2003). The Economic Theory of Fiscal Policy, Volume 3. Routledge.
  • Anderson, J. E. (2005). Fiscal Reform and its Firm-Level Effects in Eastern Europe and Central Asia, Working Papers Series wp800, William Davidson Institute at the University of Michigan.
  • D. Harries. Roger Fenton and the Crimean War
  • Schmidt, M (2018). "A Look at Fiscal and Monetary Policy", Dotdash
  • Pettinger, T. (2017). "Difference between monetary and fiscal policy",
  • Amadeo, K. (2018). "Fiscal Policy Types, Objectives, and Tools", Dotdash
  • Kramer, L. (2019). "What Is Fiscal Policy?", Dotdash
  • Macek, R; Janků, J. (2015) "The Impact of Fiscal Policy on Economic Growth Depending of Institutional Conditions"

External links

This page was last edited on 22 June 2019, at 10:03
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