Just like the Federal Reserve is responsible for monetary policy, fiscal policy falls under the responsibility of the government.
Fiscal Policy involves accelerating or slowing down economic activity, with the help of taxes and government spending. Specifically, the aim is to influence aggregate demand for goods and services, employment, inflation and economic growth.
US fiscal policy is primarily based on the ideas of famous British economist, John Maynard Keynes. He believed that recessions are due to a shortfall in consumer spending and business investment, and thus governments could stabilise the business cycle through regulating economic output by adjusting spending and tax policies. Consequently, this would make up for the shortcomings of the private sector.
According to Keynes, aggregate demand (the combination of consumer, business, net government spending and net exports) is what drives the performance and growth of the economy.
The “shortfalls” highlighted in the private sector by Keynes were due to psychological factors like pessimism and fear, and therefore government intervention was necessary in maintaining sustained growth. Essentially, through the use of taxation and spending, the government could impede the excess and deficiencies of spending in the private sector.
When spending/consumption in the private sector decreases, the government can spend more or decrease taxes in order to increase aggregate demand. This is known as expansionary fiscal policy. For example, the government can build more schools, which would increase employment and push up demand.
On the other hand, when the private sector spends too much, the government can spend less or increase taxes in order to decrease aggregate demand. This is known as contractionary fiscal policy. For example, the government can push the economy into a brief recession, in hopes of restoring balance to the economic cycle.
There are disadvantages on both sides of fiscal policy: expansionary policy can be difficult to reverse, sometimes leading to high inflation and asset bubbles. Contractionary policy can push an economy into a recession, which can seriously damage the economy. Moreover, the effects of fiscal policy aren’t felt equally by everyone. A tax cut could only affect the middle class or building a new bridge will only provide jobs to construction workers.
As a result, fiscal policy is often considered a less precise tool than monetary policy.