What is Fiscal Policy? - Definition, Effects & Example

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  • 0:01 What Is Fiscal Policy?
  • 0:21 Effects on Economy
  • 4:36 Lesson Summary
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Lesson Transcript
Instructor: Shawn Grimsley

Shawn has a masters of public administration, JD, and a BA in political science.

Government taxing and spending has broad implications for the overall economy. In this lesson, you'll learn about fiscal policy, what it is and how it affects the economy.

What Is Fiscal Policy?

Fiscal policy involves the decisions that a government makes regarding collection of revenue, through taxation and about spending that revenue. It is often contrasted with monetary policy , in which a central bank (like the Federal Reserve in the United States) sets interest rates and determines the level of money supply.

Effects on Economy

Fiscal policy and monetary policy can have dramatic effects on the economy. Let's discuss those effects in more detail.

Government Spending

The single largest consumer of goods and services in the United States is the United States government. Let's take a look at some numbers. Total government spending in 2011 consisted of about $3.6 trillion in federal spending, $1.5 trillion in state spending and $1.6 trillion in local government spending -- that's $6.1 trillion! If the government actually stopped spending, our economy would collapse.

Government spending affects nearly every sector of the economy. The federal government spends money on such things as national defense, entitlement programs (such as Social Security and Medicare), interest on the national debt and discretionary spending that ranges from purchasing paper clips and funding scientific research to building infrastructure and subsidizing farms. State and local governments spend money on roads, schools and infrastructure. The best way to look at the scope of government spending is to take a look at the federal budget:

As you can see, government spending pumps tremendous amounts of money into the hands of citizens through entitlement programs where they can spend it on goods and services that are purchased from regular businesses. The government also pumps a tremendous amount of money into the hands of private businesses when it purchases goods and services, ranging from pencils to multi-billion dollar aircraft carriers. All this economic activity helps grow the economy and create jobs and, ideally, it will improve the lives of citizens.

Government spending has also been considered a paramount tool during times of economic hardships, such as during periods of high unemployment, recessions and depressions. According to one school of thought, known as Keynesian economics, a government should spend money during times of economic downturns to stave off recessions and depressions.

The idea is that government spending helps offset the drop in private sector spending by consumers and businesses to stimulate growth. If the government is buying, then businesses can sell and employees can work, which increases the money available for both business and consumer spending. Eventually, the private sector spending will pick up and government spending can decline. The greatest example of this approach is the Great Depression era 'New Deal.'


The other half of the fiscal policy is taxation. First, the government is like any other consumer -- it can't buy anything without money or credit. The government generates revenue primarily through a system of taxes. Taxes can be generated from income, sales, property and transfers of property at death, for example. Here's a chart showing the government tax revenue in 2011:

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