The term fiscal policy refers to the process by which the government spends the revenues collected from its citizens to influence the direction of an economy. Fiscal policy is typically aligned with monetary policy, which is controlled by the country’s central bank.
In order to fund its expenditures, governments collect money from its citizens, typically in the form of a tax. This revenue stream is then put to work, paying for essential services. Fundamental fiscal policy involves a decision to spend more, lower taxes, or do a combination of the two. Determining the correct mix of public spending versus collecting taxes is referred to as the balancing act.
Fiscal policy is based on Keynesian economic theory, which states that a government can influence its economy by decreasing or increasing taxes and / or public spending.
Fiscal versus Monetary Policy
Monetary policy is determined by a country’s central bank and its principal tool is the money supply. By increasing or decreasing the supply of money, the central bank can expand or contract an economy. In the same manner, fiscal policy can be used to expand or contract an economy. Fiscal policy can influence an economy through its spending. When the objective is to expand an economy, a government can spend more than it collects from its citizens, thereby making more money available to its economy. When the objective is to control inflation, a government can reduce its spending. Oftentimes this decision is one of creating a budget deficit versus a surplus.