What is Fiscal Policy? | Definition, Examples, Importance, & Facts

Let us for a minute think of our Indian Economy as a person. Let us also assume that the economy has fallen sick, just like how humans fall sick.

In humans, the signs of sickness could be anything from fevers to headaches. The signs of a sick economy, however, are a bit different. An economy that is not doing well shows signs like increasing unemployment, low investment, increasing inflation, stock market crashes, etc.

When the economy has fallen sick, it needs a team of doctors to treat it. This team of doctors includes the Central Bank of the country and the Central Government. The Central Government and the Central Bank can introduce various treatment plans to make the economy healthy again!

There are two popular methods that both our doctors rely on to treat our economy. These are monetary policy and fiscal policy. Doctors specialize in different branches of medicine. Our economy doctors, too, specialize in different branches for treating the economy.

The Central Bank of our country specializes in managing monetary policy. The Central Bank is the national bank of the country that looks after the supply of the country’s currency to help maintain economic stability. In India, The Reserve Bank Of India, also known as RBI, is the Central Bank.

The Central Government, on the other hand, specializes in managing fiscal policy. The Central Government is the chosen political authority that has control over the functioning of the entire economy.

Before we discuss the meaning and importance of fiscal policy, let us know a bit more about monetary policy.

Monetary Policy: What is it? How is it different from Fiscal Policy?

Like we learned before, Monetary Policy in a country is controlled by the Central Bank of the nation. Monetary Policy is all about the money supply in our country. Money Supply means the total money that people in the country hold at a particular time.

The economy can fall sick in two ways.

One where the investment is low, and the employment is low. In such a scenario, the Central Bank needs to energize the economy by increasing the money supply. When the Central Bank increases the money supply in the economy, businesses and consumers start responding by spending more as they have more money now.

The second way the economy can fall sick is when it is growing too fast. This can be seen when demand for goods in the country is high and inflation is high. Inflation is the rise in the prices of goods and services. In such a scenario, the Central Bank needs to calm the economy down by decreasing the money supply. When the Central Bank decreases the money supply in the economy, businesses and consumers start responding by spending less as they have less money now.

All these measures bring the economy to a stable state. The Central Bank increases and decreases money supply with the help of something called Open Market Operations. 

We must note that the Central Bank has a lot of non-cash assets like bonds, gold etc. The Central Bank can buy and sell government bonds or securities from commercial banks through Open Market Operations depending on the economic condition of the country.

If the Central Bank wants to reduce the money supply in the country, it can sell government bonds and securities to commercial banks. Commercial banks buy these securities and bonds, which in turn reduces their reserves, and reduces their capacity to give loans and make investments.

Similarly, If the Central Bank wants to increase the money supply in the country, it can buy government bonds and securities from commercial banks. The reserves of the commercial banks increase, and they have an increased capacity to give out loans and make investments.

These Open Market Operations are effective because it depends on the demand and supply of money. We know that the Central Bank controls the money supply of the country. The demand for money is determined by the interest rates.

These interest rates are indirectly affected due to the Open Market Operations. The Central Bank uses two types of interest rates to control the liquidity in the country. These are the Repo rate and the Reverse repo rate. Repo means ‘repurchasing option.’

Repo rate is the rate at which commercial banks can borrow from the Central Bank, RBI. They can borrow this money by selling government securities and bonds to the Central Bank with an agreement to buy them on a future date at a fixed price. The Repo Rate is the interest charged by the Central Bank to the commercial banks for the cash they borrowed.

Reverse Repo Rate is the rate at which the Central Bank borrows from the commercial banks to reduce the demand for money. The Commercial Banks are provided attractive returns if they give their funds to the Central Bank. This in turn reduces the funds available with the commercial banks for extending loans.

When the Central Bank wants to reduce the demand for money, it announces higher interest rates. This makes people want to put all their money into their bank account and carry less cash around.

 When the Central Bank wants to increase the demand for money, it announces lower interest rates. This makes people want to hold on to their money and have plenty of cash

The main difference between Monetary and Fiscal Policy is that the former is controlled by the Central Bank of India and the latter is controlled by the Central Government of India. Another difference is that the Monetary Policy mainly deals with supply and demand of money, and interest rates. The Fiscal Policy on the other hand deals with taxation and government spending.

Fiscal Policy: Meaning, Importance, Types and Tools

Sometimes, the economy falls too sick; it requires the combined help of both the doctors. Most people agree that Monetary Policy by the Central Bank is the most effective when it comes to dealing with economic instability.

 However, there could be situations when the economy is so sick that it needs fiscal policy help from the Central Government as well. We can think of these measures of Monetary Policy and Fiscal Policy as supermen and superwomen who are here to restore economic stability. 

Unlike Monetary Policy, Fiscal Policy uses taxes and spending to treat the economy.

 Types of Fiscal Policy

There are three types of fiscal policy. They are Expansionary Policy, Contractionary and Neutral Policy. In the first type, the Central Government decreases tax, in the second type the Central Government increases a tax, and in the third type, tax is kept as it is.

When the economy is showing signs of low employment, low spending, and low demand, the Central Government can boost the economy by decreasing taxes and increasing its spending on various policies for the people like unemployment benefit schemes, etc. Both these measures help in increasing employment, increasing demand and spending by the public on goods. This scenario, where the Central Government is decreasing taxes so that people spend more is also called an Expansionary Fiscal Policy.

In cases when the economy is showing signs of high demand and high inflation, the Central Government can use the Fiscal policy to slow the economic activity.  The government does this by increasing taxes and decreasing its spending on various policies for the people. This scenario where the Central Government is increasing taxes so that people spend less is called Contractionary Fiscal Policy.

There is a third type of fiscal policy, which is called Neutral Fiscal Policy. A neutral Fiscal Policy is a situation where the economy is in equilibrium and there is no need for any changes in the tax rates or government spending, so it is kept as it is.

Tools of Fiscal Policy

There are three tools of Fiscal Policy. These are government spending, taxes, and transfer payments.

Government Spending :

Central Government spending is a tool in fiscal policy because government spending can affect the overall economic activity in an economy. For example, If the central government increases spending for the production of electric vehicles in India, manufacturers of these vehicles will require more employees.

When more employees are hired and paid, then they will go out and purchase other goods with their salaries, this, in turn, increases the GDP

Taxes:

Taxes are a tool in fiscal policy, as the government can increase or decrease taxes to maintain economic stability in the country. In Expansionary Fiscal Policy, the Central Government wants people to spend more on goods and services, and so they decrease the taxes.

Similarly, in Contractionary Fiscal Policy, the Central Government wants people to spend less on goods and services to control the rising prices in the economy, and so they increase taxes.

Transfer Payments

Transfer Payments are those payments made by the government for equal distribution of income. Most economies today are welfare states and in a welfare state, the government has to look after social issues like poverty, the gap between the rich and the poor.

Transfer Payments are fiscal tools because the government can use transfer payments to redistribute income in an economy by increasing taxes and then spending the revenue received through taxes on employment programs like Mahatma Gandhi National Rural Employment Guarantee Scheme (MGNREGA).

Importance of Fiscal Policy

The importance of fiscal policy in an economy can be explained with the help of the following points:

• Fiscal Policy helps in maintaining economic stability in the country through changes in taxes and government spending.

• If the government needs money to spend on various projects and schemes for the people, it can collect the money from the citizens of the country in the form of tax.

•  Fiscal policy helps in controlling inflation and deflation in an economy that in turn maintains price stability. Price stability is the general level of prices in the country.

• Fiscal tools can help in reducing inequalities of income and wealth in a country by spending government revenue earned through taxes on social welfare activities.

• In developing countries, fiscal policy is helpful in accelerating economic growth.

Conclusion

When the economy is not doing well, it needs the help of the Central Government and the Central Bank to make it better. The Central Bank uses Monetary Policy to stabilize the economy. Monetary Policy can bring changes to the demand and supply of money, and interest rates. However, it is possible that sometimes Monetary Policy is not enough to bring the economy back to track.

In such a scenario, Fiscal Policy controlled by the Central Government is useful. Fiscal Policy can bring changes to taxes, government spending, and transfer payments. The types of Fiscal Policy are Contractionary Policy, Expansionary Policy, and Neutral Policy. The type of policy that needs to be used depends on the economic situation in a country.

Frequently asked questions related to Fiscal Policy:

1. What is fiscal policy?

Fiscal policy is a tool that helps in keeping the economy stable. In Fiscal Policy, the government decides the money it should spend on economic activities and the revenue it can get through taxes for spending on the economy.

• What are the tools of fiscal policy?

The three tools of Fiscal Policy are Transfer Payments, Government Spending, and Taxes.

• Why is fiscal policy important in a welfare state?

In a welfare state, the government needs to spend on the welfare of the people. Fiscal policy can help a welfare state through redistribution of income in favor of the poor and by spending the revenue earned on social welfare activities

• Is fiscal policy effective?

Yes, fiscal policy is effective in bringing economic stability to a country. It affects income, the output of the country in the form of goods and services, and the spending of the people.

• How does fiscal policy affect employment in a country?

One of the main objectives of fiscal policy is full employment. Fiscal Policy can be used to increase employment in the country. The Central Govt can use expansionary fiscal policy to increase demand in the economy for goods and services, which in turn increases the number of jobs available.

• What is the difference between fiscal and monetary policy?

Monetary Policy is implemented by the Central Bank of the country, and it controls the money supply, money demand and interest rates in an economy. Fiscal Policy is implemented by the Central Government of India, and it controls the taxes, government spending.

• Who controls fiscal and monetary policy?

Fiscal Policy is controlled by the Central Government of the country and the Monetary Policy is controlled by the Central Bank of the country.

• Why are the three types of fiscal policy important?

The three types of fiscal policy are expansionary, contractionary and neutral policies. They are important because depending on the economic instability in the country, the government uses a type of fiscal policy. For example, If there is high unemployment, then the government uses expansionary fiscal policy.