In a country, not only the central bank, but also the government has the right to make economic policies. Central bank is in charge of making monetary policies, while government is responsible for fiscal policies.
What is Fiscal Policy?
Fiscal Policy means the government setting spending and tax policies to influence economic conditions. Policies include demand for goods and services, employment, inflation and economic growth.
The root of fiscal policy lies in the ideas of the famous economist, John Maynard Keynes. Keynes argued that government could stabilize the business cycle.
Types of Fiscal Policy
There are two types of fiscal policies, the expansionary fiscal policy and the contractionary fiscal policy.
During a recession or an economic slowdown, government will employ expansionary policy by lowering tax rates to increase demands and economic growth.
When people pay lower taxes, they have more money in their hands to spend, which could increase the demand. The demand leads companies to hire more people.
Also, government can increase spending, for example, building highways, which could promote the employment, pushing up demand and economic growth. In that case, government may spend a lot and cause deficits.
Contractionary is the opposite. When the inflation is too high, a government can use contractionary fiscal policy to “cool down” the economic situation. Government will reduce public spending and cutting public-sector pay or jobs, raising taxes as well.
While expansionary fiscal policy leads to deficits, contractionary fiscal policy leads to budget surplus. However, this policy is rarely used.
When fiscal policy is neither expansionary nor contractionary, it is neutral.