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What Are the Different Instruments of Fiscal Policy?

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  • Written By: K. Kinsella
  • Edited By: Shereen Skola
  • Last Modified Date: 11 April 2014
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Governments use instruments of fiscal policy to try and control local, national and even international economies. Policy instruments fall into two main categories: expenditure polices, and revenue generation plans. The former include initiatives aimed at bolstering consumer or business lending as well as plans to raise the standard of living by injecting cash into development and revitalization projects while the latter include various types of taxes and tariffs that governments assess on consumers and commercial enterprises.

Growth occurs when spending increases and the economy expands but in order for growth to occur consumers and businesses must have access to credit. Widely used instruments of fiscal policy that are designed to encourage growth include government backed lending programs. In many instances, governments either finance or insure consumer mortgages with the intention of making these loans more accessible to people who live on modest budgets. When home financing options become more readily available, competition for affordable homes increases and this causes prices to rise. Grants and tax incentives are also sometimes provided to prospective homeowners; these instruments of fiscal policy also cause home prices to rise and this drives growth.

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During periods of inflation, high levels of unemployment can inhibit economic growth. Consequently, many governments fund unemployment insurance programs that are designed to ensure that consumers have sufficient money to cover their day-to-day costs even while unemployed. These programs help not just the recipients but also the economy at large because the money that these people spend creates profits for private companies. Profitable firms tend to expand in order to maximize profits and expansion often takes the form of job creation. Therefore, widely used instruments of fiscal policy include job creation programs and plans that provide businesses with low cost loans and tax incentives.

Aside from attempting to stimulate growth, fiscal policy instruments can also be used to combat inflation. Governments generate revenue but assessing various taxes on businesses and consumers. As taxes rise, discretionary spending decreases since consumers have to spend a higher percentage of their money on day-to-day essentials. Likewise, taxes also affect businesses which means that governments can use these instruments of fiscal policy to prevent overly aggressive firms from expanding too rapidly.

Fiscal policy tools impact the domestic economy but tariffs are tools that can impact the economy in other nations. Tariffs are usually imposed on imported goods, and as tariffs rise the cost of buying overseas goods rises. Foreign producers either have to raise prices to cover the cost of these taxes or eliminate other expenses. If these firms raise prices then the tariffs have created inflation but if these firms cut costs then the tariffs may result in job losses overseas. Therefore, tariffs are among the fiscal policy tools that have the most far-reaching impact.

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Discuss this Article

candyquilt
Post 3

@burcinc-- That's right. Almost always, a different monetary policy will be enough to help the economy recover. But if the situation is very bad, such as during a recession, then fiscal policies will also be necessary. This is actually when fiscal policies, like increased government spending, is most effective.

If the economy is not in a very bad situation, greater government spending will not be as helpful because it might end up limiting private sector spending. This is especially true if the government is borrowing money from the private sector.

I guess we could say that increase in expenditure is not the best fiscal policy instrument. It should only be used when it's really necessary.

burcinc
Post 2

@fBoyle-- I hadn't thought of it that way before. But the government doesn't always change fiscal policy right? Isn't monetary policy usually used to manage the economy?

fBoyle
Post 1

Aside from these, the government can also increase government spending if the economy is slow. This adds to the money supply which helps stimulate the economy. The downside to using fiscal policy to improve the economy is that it almost always has repercussions. For example, more government spending usually means a greater budget deficit. And the government may have to borrow money to deal with that deficit.

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