Fiscal Policy

What is Fiscal Policy?


*noun*, efforts by the government to intentionally run a deficit in order to stimulate the economy during a recession. Loosely associated with Keynesian economics.

According to basic economic theory, recessions occur because there is a basic mismatch between aggregate demand and potential output. One approach for solving this is for the government to buy more goods and services than it has revenues to cover, thereby creating conditions in which effective demand is greater than the stock of goods currently in business inventory (given recessionary prices).

Under a stimulus, the jolt of extra money in circulation creates inflation, which has the effect of lowering real prices. Customers then respond to the {de facto} price reduction by buying more, which leads to more hiring, thence to more effective demand, thence to economic recovery.

Another reason fiscal policy stimulates the economy is that the private sector is not investing or consuming its own output. Increased taxes would simply reduce private consumption, so those cannot be increased; but spending is increased to fill the breach.

I think it is possible that fiscal policy will have even more 'oomph' in this situation," Christina Romer, who heads the Council of Economic Advisers, told an economics conference.

"When households and businesses are liquidity-constrained by reduced lending, any money put in their pockets is more likely to be spent," she said.

--Reuters, "White House's Romer: Stimulus may pack more punch" (3 March 2009)

See monetary policy, keynesian, keynesianism, economics, recession


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