How does the fiscal policy work?

Iqbal Khan

Fiscal policy is a tool the government uses to influence the economy in a specific direction. This is done by adjusting its spending levels and taxation policy. The government implements the fiscal policy in conjunction with the monetary system (where the RBI manages the nation’s money supply) to reach the different economic goals set for the year. This includes healthy economic growth, a decrease in unemployment, steady inflation and rise in business growth.

How does fiscal policy work?

As a concept, fiscal policy is based mainly on the economic theories of world-renowned British economist John Maynard Keynes. The theory suggests that a government can influence the country’s macroeconomic productivity by either increasing or decreasing the public spending and tax levels.

Types of fiscal policy

There are two types of fiscal policy.

a) Expansionary fiscal policy

b) Contractionary fiscal policy

Expansionary fiscal policy

An expansionary fiscal policy aims to encourage economic growth by increasing government spending, lowering interest rates and or cutting taxes. For instance, the government can increase its spending on infrastructure projects to boost growth or offer tax cuts, transfer payments or rebates to taxpayers. It is the most widely used form of fiscal policy.

The fundamental idea here is to ensure greater disposable income into consumer’s hands. This way, they can afford to spend more on goods and services. This increase in demand not only helps to boost business growth but also aids in job growth across various sectors and industries.

Contractionary fiscal policy

The other type of monetary policy is contractionary fiscal policy. The goal of this policy is to slow down economic growth in the country. This statement may not make much sense at face value. Why would the government want to slow down economic activity and growth?

There is only one primary reason for this policy: To curb inflation.

If inflation is too high, the effects can be quite damaging. It raises the cost of living and consumers would lose purchasing power. Over the long-term, its results can be as harmful as a recession in the economy.

When inflation is extreme, it may be time for a slowdown in the economy for a brief period. In such situations, the government resorts to a contractionary fiscal policy to remove money out of circulation in the economy.

In this strategy, the government increases taxes and cuts spending. This can be quite unpopular among consumers, and it can result in negative side effects such as a rise in unemployment levels and a sluggish economy.

How does the fiscal policy affect people?

Fiscal policies affect different sections of people in various ways. For instance, India has a sizeable middle-class population. So, if the government offers a tax cut to the middle class as part of expansionary fiscal policy, it can have a positive impact on a large number of people. On the other hand, a decision by the government to increase government spending on infrastructure in a particular town or village affects only that location. This decision helps to develop the town and provide jobs and income to lots of people in that area.


Fiscal policy has a direct and measurable impact on employment levels as well as consumer income. It is a valuable tool the government uses (along with monetary policy) to control and stabilise the economy.