How Fiscal Policy Affects Inflation and Unemployment

A Practical Guide for Understanding Government Economic Strategy (UK & US Edition) 

Governments play a crucial role in managing economic stability. One of their most powerful tools is fiscal policy, which involves adjusting public spending and taxation to influence key economic outcomes—especially inflation and unemployment. 

In this guide, you'll learn: 

• What fiscal policy is 

• The difference between expansionary and contractionary policies 

• How it influences inflation and unemployment 

• Real-world examples from the UK and US 

• Why timing and context are critical 

What Is Fiscal Policy? 

Fiscal policy refers to how a government uses taxation and spending to influence economic activity. Unlike monetary policy (managed by central banks), fiscal policy is controlled by elected officials and legislative bodies. 

The Two Main Types of Fiscal Policy: 

• Expansionary: Used to stimulate economic growth by increasing government spending or cutting taxes. 

• Contractionary: Used to reduce inflation or debt by decreasing spending or raising taxes. 

Both have significant impacts on national economies, job markets, and living costs. 

How Fiscal Policy Affects Inflation 

Inflation is the rate at which prices for goods and services rise over time, eroding purchasing power. 

Expansionary Fiscal Policy Can Increase Inflation 

When governments spend more or reduce taxes, it increases the amount of money in circulation. This boosts demand, which can outpace supply and drive up prices. 

Example In the US, the COVID-19 stimulus packages injected trillions into the economy through direct payments, enhanced unemployment benefits, and business support. In the UK, the furlough scheme and business grants had a similar effect. While these measures softened the economic blow of the pandemic, they were followed by significant inflation increases in both countries. 

Contractionary Fiscal Policy Can Reduce Inflation 

Governments can reduce inflation by slowing demand—cutting public spending or increasing taxes. With less disposable income circulating, demand eases, helping to stabilise prices. 

Example Post-2008, the UK government introduced austerity measures to reduce public debt and suppress potential inflation. While inflation was brought under control, growth and public service funding were affected. 

How Fiscal Policy Affects Unemployment 

Unemployment refers to the percentage of people actively looking for work who cannot find jobs. Fiscal policy has a direct influence here. 

Expansionary Policy Reduces Unemployment 

When a government increases spending—especially on infrastructure, education, or public services—it creates jobs directly and indirectly. Lower taxes also leave businesses and consumers with more money, encouraging hiring and investment. 

Example In the wake of the 2008 financial crisis, the US launched the American Recovery and Reinvestment Act, which aimed to reduce unemployment by investing in public projects and offering tax incentives. Similar job-creating initiatives were seen in the UK through temporary tax relief and training programmes. 

Contractionary Policy Can Increase Unemployment 

If the government cuts spending, public sector roles may be reduced. Higher taxes can discourage business growth, reducing hiring. 

Example The UK’s austerity policies led to reductions in public sector employment and services, with unemployment rising in affected regions. 

The Inflation–Unemployment Relationship 

This relationship is often described by the Phillips Curve, which suggests an inverse link between inflation and unemployment: 

• When unemployment falls, inflation tends to rise. 

• When unemployment rises, inflation tends to fall. 

In practice, this balance is complex and influenced by many external factors, including global supply chains, interest rates, and consumer confidence. 

UK vs US Fiscal Policy: A Brief Comparison 

Feature	United Kingdom	United States
Fiscal Authority	HM Treasury and Parliament	Congress and the President
Post-2008 Focus	Austerity and deficit reduction	Stimulus and job recovery
COVID-19 Response	Furlough schemes, business grants	Direct stimulus payments, PPP loans
Current Trend	Balancing inflation control with cost-of-living support	Managing inflation while avoiding recession

Why Timing Matters 

Fiscal policy is most effective when timed correctly. Poorly timed measures can lead to: 

• Overheating the economy (too much stimulus, driving inflation) 

• Deepening a recession (cutting spending too soon) 

Coordination between fiscal policy and monetary policy—like interest rate decisions from the Bank of England or Federal Reserve—is essential to maintain economic balance. 

Key Takeaways 

• Fiscal policy is a powerful tool that directly impacts inflation and unemployment. 

• Expansionary fiscal policy can boost employment but may increase inflation. 

• Contractionary fiscal policy can control inflation but may lead