Overview

The government has two levers to steer the economy: Monetary Policy (Interest Rates) and Fiscal Policy (Taxes and Spending). Fiscal Policy is the power of the purse. It is Congress deciding to build a bridge or cut taxes to create jobs.

Core Idea

The core idea is Aggregate Demand. The total amount of spending in the economy.

  • Recession: People are scared, so they stop spending. Businesses fire people.
  • Solution (Keynesian): The government should step in and spend money (Stimulus) to fill the gap. “Prime the pump.”

Formal Definition

The use of government spending and tax policies to influence economic conditions. Expansionary: Lower taxes, higher spending (Gas pedal). Contractionary: Higher taxes, lower spending (Brake).

Intuition

  • Family Budget: If a family is broke, they spend less.
  • Government Budget: If the economy is broke, the government should spend more. It’s counter-intuitive. The government acts as the “Spender of Last Resort.”

Examples

  • The New Deal (1930s): FDR hired millions of unemployed people to build roads, dams, and parks. It put money in their pockets, which they spent at grocery stores, which hired more people.
  • COVID Stimulus Checks (2020): The government sent checks to everyone to keep the economy from collapsing during the lockdown.
  • Austerity: The opposite. Cutting spending during a crisis. (Greece in 2010). Most economists now think this makes things worse.

Common Misconceptions

  • The Deficit: “The government is running out of money.” A country that prints its own currency (USA, Japan) cannot “run out” of money. The limit is inflation, not bankruptcy.
  • Multiplier Effect: If the government spends $1, it creates $1.50 of economic activity because the construction worker spends his wages at the bar, and the bartender spends his tips at the store.
  • Crowding Out: If the government borrows too much, it uses up all the available loan money, making it harder for businesses to borrow.

Applications

  • Infrastructure Bill: Spending $1 Trillion on bridges and internet. It creates jobs now and makes the economy more efficient later.

Criticism / Limitations

  • Lag: By the time Congress agrees on a stimulus bill, the recession might already be over.

Further Reading

  • Keynes, John Maynard. The General Theory of Employment, Interest and Money.
  • Kelton, Stephanie. The Deficit Myth.