June 18, 2019
Introduction to U.S. Economy: Fiscal Policy
What is Fiscal Policy?
strengthening U.S. dollar, which results in a growing trade
Fiscal policy is the means by which the government adjusts
deficit. Third, it can lead to accelerating inflation in the
its budget balance through spending and revenue changes to
economy, which tends to interfere with the efficient
influence broader economic conditions. According to
operation of the economy. All of these side effects from
mainstream economics, the government can impact the
expansionary fiscal policy tend to put downward pressure
level of economic activity—generally measured by gross
on economic activity, and therefore work against the
domestic product (GDP)—in the short term by changing its
original stimulus generated through expansionary fiscal
levels of spending and tax revenue. This In Focus presents
policy.
an introduction to fiscal policy. For a more in-depth look at
fiscal policy, its effect on the economy, and its use by the
Expansionary fiscal policy’s ultimate effect on the economy
government, refer to CRS Report R45723, Fiscal Policy:
depends on the relative magnitude of these opposing forces.
Economic Effects, by Jeffrey M. Stupak.
In general, the increase in economic activity resulting from
expansionary fiscal policy tends to be greatest during a
Expansionary fiscal policy—an increase in government
recession. This is because the positive effect of
spending, a decrease in tax revenue, or a combination of the
expansionary policy tends to be largest during a recession
two—is expected to temporarily spur economic activity.
and the negative side effects tend to be smallest.
Conversely, contractionary fiscal policy—a decrease in
government spending, an increase in tax revenue, or a
Contractionary Fiscal Policy
combination of the two—is expected to temporarily slow
As the economy shifts from a recession and into an
economic activity.
expansion, broader economic conditions will generally
improve, whereby unemployment falls and wages and
Expansionary Fiscal Policy
private spending increase. With improving economic
Recessions can have serious negative consequences for
conditions, policymakers may choose to begin withdrawing
both individuals and businesses. During a recession,
fiscal stimulus by decreasing the size of the deficit or
aggregate demand (overall spending) in the economy falls,
potentially by applying contractionary fiscal policy and
which generally results in slower wage growth, decreased
running a budget surplus.
employment, lower business revenue, and lower business
investment. As such, policymakers may want to intervene
The government can implement contractionary fiscal policy
in the economy when a recession occurs by implementing
by increasing taxes, decreasing spending, or a combination
expansionary fiscal policy to mitigate the decline in
of the two. When the government raises individual income
aggregate demand.
taxes, for example, individuals have less disposable income
and generally decrease their spending on goods and services
Expansionary fiscal policy can take the form of increased
in response. The decrease in spending temporarily reduces
government spending, decreased tax revenue, or a
aggregate demand for goods and services, slowing
combination of the two. Government spending takes the
economic growth temporarily. Alternatively, when the
form of both purchases of goods and services by the
government reduces spending, it reduces aggregate demand
government, which directly increase economic activity, and
in the economy, which again temporarily slows economic
transfers to individuals, which indirectly increase economic
growth. As such, when the government implements
activity as individuals spend those funds. Decreased tax
contractionary fiscal policy, regardless of the mix of fiscal
revenue via tax cuts indirectly increases aggregate demand
policy choices used to do so, aggregate demand is expected
in the economy. For example, an individual income tax cut
to decrease in the near term.
increases the amount of disposable income available to
individuals, enabling them to purchase more goods and
However, contractionary fiscal policy is expected to interact
services. Standard economic theory suggests that in the
with similar economic processes as does expansionary
short term, fiscal stimulus can lessen a recession’s negative
fiscal policy, except in reverse. Contractionary fiscal policy
impacts or hasten a recovery.
is expected to reduce interest rates, leading to additional
investment, and weaken the U.S. dollar, leading to more
However, expansionary fiscal policy’s effectiveness may be
U.S. exports and fewer imports and a slowing of inflation.
limited by its interaction with other economic processes,
All of these side effects tend to spur additional economic
including interest rates and investment, exchange rates and
activity, partly offsetting the decline in economic activity
the trade balance, and the rate of inflation. First,
resulting from contractionary fiscal policy.
expansionary fiscal policy is expected to result in rising
interest rates, which puts downward pressure on investment
The ultimate impact on the economy of withdrawing fiscal
spending in the economy. Second, it can lead to a
stimulus depends on the relative magnitude of its effects on
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Introduction to U.S. Economy: Fiscal Policy
aggregate demand, interest rates and investment, exchange
greater individual and corporate income tax revenues.
rates and the trade deficit, and inflation.
Federal spending on income support programs, such as food
stamps and unemployment insurance, tends to fall during
Long-Term Fiscal Policy Considerations
economic expansions as fewer people need financial
Persistently applying fiscal stimulus can negatively affect
assistance and file unemployment claims. The combination
the economy through three main avenues. First, persistent
of rising tax revenue and falling federal spending tends to
large budget deficits can result in a rising debt-to-GDP ratio
improve the government’s budget deficit. The opposite is
and lead to an unsustainable level of debt. A rising debt-to-
true during recessions, when federal spending rises and
GDP ratio can be problematic if the perceived or real risk of
revenue shrinks. These cyclical fluctuations in revenue and
the government defaulting on that debt begins to rise. As
spending are often referred to as automatic stabilizers.
the perceived risk of default begins to increase, investors
Therefore, when examining fiscal policy, it is often
will demand higher interest rates to compensate themselves.
beneficial to estimate the budget deficit excluding these
Second, persistent fiscal stimulus—particularly during
automatic stabilizers, referred to as the structural deficit, to
economic expansions—can limit long-term economic
get a sense of the affirmative fiscal policy decisions made
growth by crowding out private investment, as it is an
each year by Congress.
important determinant of the economy’s long-term size.
Third, rising public debt will require a growing portion of
Figure 1. Federal Budget Deficit/Surplus
the federal budget to be directed toward interest payments
on the debt, potentially crowding out spending on other
policy priorities.
Monetary Policy
Fiscal policy is not the only policy lever available if the
government wishes to influence broader economic
conditions. The Federal Reserve implements monetary
policy by influencing interest rates throughout the
economy. The Federal Reserve can spur economic activity
by lowering interest rates and slow economic activity by
doing the opposite. Monetary policy can also be used in
conjunction with fiscal policy to limit the undesirable
aspects of expansionary or contractionary fiscal policy. For

example, expansionary fiscal policy tends to have the
Source: Federal Reserve Bank of St. Louis and U.S. Office of
undesirable effect of increasing interest rates; however, the
Management and Budget, https://fred.stlouisfed.org/series/
Federal Reserve could combat this by pushing interest rates
FYFSGDA188S.
down through monetary policy. Monetary policy is set
Note: Grey bars denote recessions as determined by the National
independently of fiscal policy, so it is also possible for the
Bureau of Economic Research.
Federal Reserve to pursue monetary policy that neutralizes
fiscal policy. For a more detailed discussion regarding
As shown in Figure 1, budget deficits tend to increase
monetary policy, refer to CRS Report RL30354, Monetary
during and shortly after recessions (denoted by grey bars)
Policy and the Federal Reserve: Current Policy and
as policymakers attempt to buoy the economy by applying
Conditions, by Marc Labonte.
fiscal stimulus. This can be seen explicitly by viewing the
Fiscal Policy Stance
structural deficit or surplus, as this only shows affirmative
changes in fiscal policy made by Congress. The budget
As shown in Figure 1, the federal government has
deficit then tends to shrink as the economy enters into
generally been running a budget deficit for much of the past
recovery and fiscal stimulus is less necessary to support
50 years—save for two short periods in the 1960s and
economic growth. However, in recent years, the federal
1990s. This suggests that the federal government has been
budget has bucked this trend. After the structural deficit
applying some level of fiscal stimulus to the economy for
peaked in 2009 at roughly 7.5% of GDP, it began to decline
much of the previous several decades, although the level of
through 2014, falling to about 2.0% of GDP. Beginning in
stimulus has increased and decreased over time.
2016, despite relatively strong economic conditions, the
structural deficit has started to rise again, nearing 4.0% of
Examining the overall budget deficit to judge the level of
GDP in 2018.
fiscal stimulus can be misleading, as the levels of federal
spending and revenue differ over time due to changes in the
state of the economy, rather than deliberate choices made
Jeffrey M. Stupak, Analyst in Macroeconomic Policy
each year by Congress. During economic expansions, tax
IF11253
revenue tends to increase and spending tends to decrease
automatically, as rising incomes and employment result in

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Introduction to U.S. Economy: Fiscal Policy



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