Fiscal policy is the tax-and-spending portion of government economic policy (not to be confused with monetary policy, which is primarily conducted by the Federal Reserve and regards adjustments in the money supply). High levels of spending and/or low taxes is considered expansionary fiscal policy, while austerity (low spending and/or high taxes) is considered contractionary fiscal policy.
Like monetary policy, the efficacy of fiscal policy is hotly contested in the economic literature. The most common school of thought is associated with John Maynard Keynes (“Keynesianism”) which, in a nutshell, argues for increasing government spending and lowering taxes during recessions and practicing austerity during boom times. Many (but certainly not all) macro-economists now consider themselves “neo-Keynesian”.
It is worth exploring the intuition behind Keynesianism. In the original Keynesian model, there is a tradeoff between unemployment and inflation: low unemployment tends to correlate with high inflation and vice-versa (this relationship is called the Phillips Curve). Keynes argued that during recessions, there is insufficient aggregate demand, and that the government should fill that void by spending lavishly. That would both lower unemployment and prevent deflation.
However, the stagflation (high inflation and high unemployment) of the 1970s revealed the severe structural weaknesses of this model. The neo-Keynesian models attempted to explain this puzzle by building up the micro-foundations of the model. They observed that prices and wages are somewhat sticky (slow to react). Suppose out of the blue everyone decided to stop spending (maybe a bank failed and everyone is skittish). In a perfect market, prices would fall until they reached market-clearing levels and wages would adjust downwards (since, for instance, the value of the marginal waiter is lower when few people are going to restaurants). In this perfect model, unemployment would not rise (because the wages would adapt to the new reality) and spending would resume (because the prices immediately adapted to the new reality). But in a world of sticky prices and wages, that does not happen. Because prices are above clearing levels, people do not spend. And because people do not spend, wages are above clearing levels and firms have to lay people off.
How does fiscal policy “solve” this conundrum? In this model, the government steps up and does the spending itself. The government does not literally go out and buy restaurant meals, but by transferring money to citizens in the form of tax cuts, stimulus checks, anti-poverty measures and wages (for direct hiring), they can induce people to go out and spend more. With the juiced up spending, the “true” price and wage level will approximate the current sticky price and wage level, and thus deflation and unemployment can be avoided.
Not everyone is satisfied with this explanation, however. Some early economists pointed to a concept called “Ricardian equivalence” to explain the weakness of fiscal policy. Namely, because the extra government spending has to be financed by debt that eventually has to be paid off with higher taxes or lower spending in the future (inducing people to save more in anticipation), fiscal policy ought to have no effect. Empirical evaluations, however, suggest that Ricardian equivalence does not hold in the real world (in part due to people’s hyperbolic discounting of the future).
Others point to the slowness of fiscal policy as its core weakness. Infrastructure projects (a common form of stimulus) can take years to wind their way through environmental review and are thus a poor way to stimulate a weakened economy that needs help immediately. Even simple transfers can take months to implement. These economists argue that monetary policy, which can act immediately, is thus far preferable.
Public choice criticisms also dog fiscal policy advocates. Public choice is a subdiscipline of economic analysis that argues that policy is set by discrete groups of interests (like lawmakers) that complicate the ability to achieve the group goal. For instance, they’d note that fiscal policy may direct more funding towards the interests of influential Senators or towards politically sympathetic causes, instead of areas that deliver maximum impact. For instance, public choice helps explain why Congress may prefer to means-test stimulus checks and unemployment check–even at the expense of a large administrative burden that means many eligible individuals do not receive their benefits and may slow down implementation by months–because of the political costs of accidentally giving out money to the “undeserving”. Public choice may also explain why despite Keynesianism suggesting austerity measures in good economic times, the government tends to maintain lavish deficit programs (as in the 1980s, 2000s and late 2010s) in order to avoid cutting off funding to favored groups.
Finally, it is worth flagging that not all recessions are demand-based. Supply shocks (such as the COVID-19 recession or the 1970s recession) are a kind of shock where production is made more difficult than before. In 2020, there was both an adverse demand shock as people did not want to go to the store because of fear of contracting the virus and people had less need for office-wear when they do not need to commute to the office and an adverse supply shock as lots of workers are out sick and governments shut down some in-person businesses. Under an adverse supply shock, the wages are above the equilibrium level because if (for instance) it becomes more expensive to produce a house since half of the lumberjacks are out sick, then the profit per house is lower and the value of a marginal house constructor goes down. But unlike in a demand shock, the prices are under the equilibrium level since if it costs more to produce a good when workers are out sick, then the price of the end good should rise if prices were flexible. As a result, juicing demand through expansionary fiscal policy may succeed at reducing unemployment, but it will have the side effect of raising inflation. Many economists attribute this dynamic to the mass inflation of the 1970s and early 2020s.
Despite these criticisms, most economists are quite sympathetic to the power of fiscal policy. For instance, many criticize the federal government for insufficiently expansionary fiscal policy from 2008-2015. In short, fiscal policy is far from a panacea from macroeconomic woes, but it is a useful tool nonetheless.