Tools of Fiscal PolicyThe first tool is taxation, whether of income, capital gains from investments, property, sales or just about anything else. Taxes provide the major revenue source that funds government. The downside of taxes is that whatever or whoever is taxed has less income to spend themselves. That makes taxes very unpopular. Find out exactly how the U.S. Federal budget is funded in Federal Income and Taxes.
The second tool is spending. The government provides subsidies, transfer payments, contracts to perform all kinds of public works, and of course salaries to government employees -- to name just a few. The reason government spending is a tool is that whatever or whoever receives the funds has more money to spend, thus driving demand and economic growth.
However, the Federal government's ability to use discretionary fiscal policy to respond to economic crises is becoming more limited each year, thanks to increasing levels of mandated government spending for Medicare, Medicaid and Social Security. In addition, changing discretionary fiscal policy usually requires an Act of Congress, and this can take a long time. One exception was the ARRA, or Economic Stimulus Act, which Congress passed quickly. However, legislators knew they needed to respond quickly to the worst recession since the Great Depression.
Expansionary Fiscal PolicyA government uses expansionary fiscal policy to stimulate the economy and create more growth. This is most critical at the contraction phase of the business cycle, when voters are clamoring for relief from a recession.
How does expansionary fiscal policy work? The government spends more, or cuts taxes, or both if it can. The idea is to put more money into consumers' hands, so they spend more. This jumpstarts demand, which keeps businesses running, and hopefully adds jobs. Of course, there is a debate as to which works better. Advocates of supply-side economics prefer tax cuts, which they say frees up businesses to hire more workers to pursue business ventures. For more, see Do Tax Cuts Create Jobs?, Trickle Down Economics - Does It Work?, and Laffer Curve.
Advocates of demand-side economics say additional spending, such as public works projects, unemployment benefits, and food stamps, goes directly into the pockets of consumers, who go right out and buy the things businesses produce. For more, see Unemployment Solutions, How Extended Unemployment Benefits Boost the Economy, and 14 Ways to Create Jobs.
However, expansionary fiscal policy is usually impossible for state and local government because they often are mandated to keep a balanced budget. If they haven't created a surplus during the boom times, they usually have to cut spending to match lower tax revenue during a recession -- making it worse.
Fortunately, the Federal government has no such constraints, so it can use expansionary policy when needed. Unfortunately, this also means Congress has run up budget deficits even during boom times, despite a national debt ceiling. As a result, the critical debt-to-GDP ratio is now around 100%.
Contractionary Fiscal PolicyAs you by now have surely guessed, the purpose of contractionary fiscal policy is to slow down economic growth. Why would you ever want to do that? One reason only, and that's to stamp out inflation. That's because the long-term impact of inflation can damage the standard of living as much as a recession.
The tools of contractionary fiscal policy are used in reverse: taxes are increased, and spending is cut. You can imagine how wildly unpopular this is among voters. Therefore, it's hardly ever used. Fortunately, monetary policy is very effective in preventing inflation.
Fiscal Policy vs Monetary PolicyMonetary policy is when a nation's central bank increases the money supply, using expansionary monetary policy, or decreases it, using contractionary monetary policy. It has many tools it can use, but it primarily relies on raising or lowering the Fed funds rate. This benchmark rates then guides all interest rates. When interest rates are high, the money supply contracts, the economy cools down, and inflation is prevented. When interest rates are low, the money supply expands, the economy heats up, and a recession is avoided -- usually.
Monetary policy works faster than fiscal policy. The Fed can simply vote to raise or lower rates at its regularly FOMC meeting. It may take about six months for the effect to percolate throughout the economy.
Current Budget Spending
U.S. fiscal policy priorities are outlined in each year's Federal budget. By far, the largest portion of budget spending is mandatory, which means that existing laws dictate how much will be spent. Most of this is for Social Security, Medicare and Medicaid entitlement programs. The remaining portion of spending is discretionary, and over half of this portion goes towards defense. Find out more in U.S. Budget and Spending Primer.
Last but certainly not least, find out the latest President's budget proposal in U.S. Federal Budget - Overview and Impact on the U.S. Economy Article updated July 10, 2012