What Is Fiscal Policy? Fiscal policy describes changes to government spending and revenue behavior in an effort to influence economic outco...
What Is Fiscal Policy? Fiscal policy describes changes to government spending and revenue behavior in an effort to influence economic outcomes. The government can impact the level of economic activity (often measured by gross domestic product [GDP]) in the short term by changing its level of spending and tax revenue. Expansionary fiscal policy—an increase in government spending, a decrease in tax revenue, or a combination of the two—is expected to spur economic activity, whereas contractionary fiscal policy—a decrease in government spending, an increase in tax revenue, or a combination of the two—is expected to slow economic activity. When the government’s budget is running a deficit (when spending exceeds revenues), fiscal policy is said to be expansionary. When it is running a surplus (when revenues exceed spending), fiscal policy is said to be contractionary. From a policymaker’s perspective, expansionary fiscal policy is generally used to boost GDP growth and the economic indicators that tend to move with GDP, such as employment and individual incomes. However, expansionary fiscal policy also tends to affect interest rates and investment, exchange rates and the trade balance, and the inflation rate in undesirable ways, limiting the long-term effectiveness of persistent fiscal stimulus. Contractionary fiscal policy can be used to slow economic activity if policymakers are concerned that the economy may be overheating, which can cause a recession.
The magnitude of fiscal policy’s effect on GDP will also differ based on where the economy is within the business cycle—whether it is in a recession or an expansion.1 Expansionary Fiscal Policy During a recession, aggregate demand (overall spending) in the economy falls, which generally results in slower wage growth, decreased employment, lower business revenue, and lower business investment. As seen during the current recession caused by the Coronavirus Disease 2019 (COVID-19) pandemic, recessions often lead to serious negative consequences for both individuals and businesses.2 The government can replace some of the lost aggregate demand and limit the negative impacts of a recession on individuals and businesses with the use of fiscal stimulus by increasing government spending, decreasing tax revenue, or a combination of the two. Government spending takes the form of both purchases of goods and services, which directly increase economic activity, and transfers to individuals, which indirectly increase economic activity as individuals spend those funds. Decreased tax revenue via tax cuts indirectly increases aggregate demand in the economy. For example, an individual income tax cut increases the 1 The economy shifts from periods of increasing economic activity, known as economic expansions, to periods of decreasing economic activity, known as recessions. For more information, see CRS In Focus IF10411, Introduction to U.S. Economy: The Business Cycle and Growth, by Lida R. Weinstock. 2 For more information on the causes of recessions, see CRS Insight IN10853, What Causes a Recession?, by Marc Labonte. T Fiscal Policy: Economic Effects Congressional Research Service 2 amount of disposable income available to individuals, enabling them to purchase more goods and services. Standard economic theory suggests that in the short term, fiscal stimulus can lessen the negative impacts of a recession or hasten a recovery.3 However, the ability of fiscal stimulus to boost aggregate demand may be limited due to its interaction with other economic processes, including interest rates and investment, exchange rates and the trade balance, and the rate of inflation. Potential Offsetting Effects to Expansionary Fiscal Policy Investment and Interest Rates To engage in fiscalstimulus by either increasing spending or decreasing tax revenue, the government must increase the size of its deficit and borrow money to finance that stimulus. This can lead to an increase in interest rates and subsequent decreases in investment and some consumer spending. 4 This rise in interest rates may therefore offset some portion of the increase in economic activity spurred by fiscal stimulus. At any given time, there is a limited supply of loanable funds available for the government and private parties to borrow from—a global pool of savings. If the government begins to borrow a larger portion of this pool of savings, it increases the demand for these funds. As demand for loanable funds increases, without any corresponding increase in the supply of these funds, the price to borrow these funds (also known as interest rates) increases. Rising interest rates generally depress economic activity, as they make it more expensive for businesses to borrow money and invest in their firms. Similarly, individuals tend to decrease so-called interest-sensitive spending—spending on goods and services that require a loan, such as cars, homes, and large appliances—when interest rates are relatively higher. 5 The process through which rising interest rates diminish private sector spending is often referred to as crowding out. 6 However, the degree to which crowding out occurs is partially dependent on where the economy is within the business cycle: either in a recession or in a healthy expansion. During a recession, crowding out tends to be smaller than during a healthy economic expansion due to already depressed demand for investment and interest-sensitive spending. Because demand for loanable funds is already depressed during a recession, the additional demand created by government borrowing does not increase interest rates as much and therefore does not crowd out as much private spending as it would during an economic expansion.7 In addition to fiscal policy, the government can influence the business cycle through the use of monetary policy. Federal monetary policy is largely implemented by the Federal Reserve, an independent government agency charged with maintaining stable prices and maximum employment through its monetary policy. The Federal Reserve can influence interest rates throughout the economy by adjusting the federal funds rate, a very short-term interest rate faced 3 Chad Stone, “Fiscal Stimulus Needed to Fight Recessions,” Center on Budget and Policy Priorities, April 16, 2020,
https://www.cbpp.org/research/economy/fiscal-stimulus-needed-to-fight-recessions. 4 Laurence Ball and Gregory Mankiw, “What Do Budget Deficits Do?,” National Bureau of Economic Research (NBER), Working Paper no. 5263, September 1995. 5 Ball and Mankiw, “What Do Budget Deficits Do?” 6 Benjamin M. Friedman, Crowding Out or Crowding In? Economic Consequences of Financing Government Deficits, Brookings Institution, https://www.brookings.edu/wp-content/uploads/2016/11/1978c_bpea_friedman.pdf. 7 Alan J. Auerbach and Yuriy Gorodnichenko, “Measuring the Output Responses to Fiscal Policy,” American Economic Journal: Economic Policy, vol. 4, no. 2 (May 2012). Fiscal Policy: Economic Effects Congressional Research Service 3 by banks. Decreasing interest rates reduces the cost to businesses and individuals of borrowing funds to make new investments and purchases. Conversely, increasing interest rates raises the cost to businesses and individuals of borrowing funds to make new investments and purchases. The Federal Reserve can conduct monetary policy in a complementary nature to fiscal policy, offsetting the rise in interest rates by decreasing the federal funds rate. Alternatively, the Federal Reserve can pursue a policy that offsets stimulus, pushing interest rates up by increasing the federal funds rate.8
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