What Are the Two Types of Fiscal Policy?

Fiscal policy represents the government’s utilization of its spending power and taxation authority to influence the overall economy. This approach aims to manage macroeconomic conditions, including aggregate demand, employment rates, and inflation. By adjusting these levers, the government seeks to stabilize the economy and foster sustainable growth. The primary objective of fiscal policy is to guide economic activity toward desired outcomes without directly controlling private sector decisions.

Expansionary Fiscal Policy

Expansionary fiscal policy is implemented to stimulate economic growth, increase aggregate demand, and reduce unemployment, particularly during periods of recession or economic slowdown. Its objective is to inject more money into the economy, encouraging spending and investment to counteract downturns.

One primary tool of expansionary fiscal policy involves increased government spending. When the government allocates more funds to areas such as infrastructure projects, like road and bridge construction, or invests in public services, it directly injects capital into the economy. For instance, federal appropriations for transportation or energy projects create jobs, as construction companies hire workers and purchase materials. This spending circulates through the economy, as employees use their wages for consumption, and businesses generate profits that can be reinvested or distributed.

Another significant component of expansionary fiscal policy is tax cuts. Reducing taxes for individuals, by lowering marginal income tax rates or increasing the standard deduction, leaves taxpayers with more disposable income. With this increased purchasing power, consumers are more likely to spend on goods and services, which in turn boosts demand for businesses. Similarly, tax cuts for businesses, such as a reduction in the corporate income tax rate or the introduction of accelerated depreciation allowances, can increase their after-tax profits. This additional capital can then be used for new investments, expanding operations, or hiring more employees, contributing to overall economic expansion.

Contractionary Fiscal Policy

Contractionary fiscal policy is employed to slow down an overheating economy, curb inflation, and reduce budget deficits. It is enacted when economic growth is too rapid, leading to unsustainable price increases. The aim is to reduce the amount of money circulating in the economy.

One common method of contractionary fiscal policy involves decreased government spending. When the government reduces its expenditures, such as scaling back funding for certain federal programs or postponing large infrastructure projects, it removes demand from the economy. For example, a reduction in federal contracts for goods and services means less revenue for businesses that rely on government work, potentially leading to fewer jobs or reduced investment. This reduction in demand helps to alleviate inflationary pressures by moderating the competition for resources and goods.

Another key component of contractionary fiscal policy is tax increases. Raising taxes for individuals, perhaps by increasing marginal income tax rates or reducing available tax credits, diminishes their disposable income. With less money available, consumers tend to reduce their spending on goods and services, which helps to cool aggregate demand. Similarly, increasing corporate tax rates or eliminating certain business deductions reduces the after-tax profits of companies. This can lead businesses to cut back on investment, expansion plans, or even reduce their workforce.