There is sometimes confusion around the difference between fiscal policy and monetary policy. While both are instruments that can be used by the government to influence the economy, monetary policy employs interest rates and money supply in this effort, while fiscal policy refers to taxing and spending by government to stimulate the economy.
There are two means by which the government employs fiscal policy to influence the economy - taxing and spending. In recessionary periods, during which unemployment increases and business slows, government spending is a means of stimulating economic activity. Cutting taxes is another means by which government can put money back into the pocket of the consumer during a recession and thus stimulate economic growth. Conversely, during times of economic expansion, government may increase taxes, taking money out of the consumer's pocket in an effort to moderate economic expansion and quell inflation.
A current example of fiscal policy in action is the March 2009 passing of President Barack Obama's $787 billion economic stimulus package which combines government spending and tax cuts in a seven-fold plan to provide consumer relief, encourage consumer spending, create employment, and stimulate business production.
Specific ways in which the stimulus package purports to mitigate the effects of the recession include the creation of new jobs, enhanced unemployment benefits and health insurance for the unemployed, tax breaks for individuals and businesses, reduction in health care costs, and economic recovery payments of $250 for more than 52 million people currently receiving Social Security benefits.
The current fiscal policy in the U.S. is sometimes called a loose or expansionary fiscal policy, one in which government spending is higher than revenue. The reverse is known as a tight fiscal policy, a fiscal contraction, during which revenue outweighs spending. During a fiscal expansion, such as the one we're in now, the desired effect of spending is to restore the output of goods and services, the gross domestic product, and put employees back to work. This, in turn increases the demand for goods and services and the overall health of the economy.
Of course, the problem with fiscal policy is that it doesn't have the same impact on everyone. A fiscal policy decision such as a tax increase that impacts only a particular economic strata or a particular constituency could be perceived as an unfair decision by that group. Similarly, government spending might benefit only a specific segment of voters, creating difficulty with another segment. How much of a hand government should play in the economy is perhaps one of the biggest controversies facing policymakers and one that makes the implementation of fiscal policy a particularly difficult political matter.
This article is intended to provide general information and should not be considered legal, tax or financial advice. It's always a good idea to consult a tax or financial advisor for specific information on how certain laws apply to your situation and about your individual financial situation.