FISCAL POLICY

Fiscal Policy Definitions

Fiscal policy is the use of taxes, government transfers, or

government purchases of goods and services to shift the
aggregate demand curve.
Discretionary Fiscal Policy: government takes deliberate
actions through legislation to alter spending or taxation
policies
Expansionary Fiscal Policy
When the economy is in recession, government wants to
increase AD
Tax cut: increases consumers disposable income
Increases AD as long as consumers dont increase savings or
spending on imports
Increase in government spending: directly shifts the AD
curve
Contractionary Fiscal Policy
When economy is suffering from inflation, government wants
to decrease AD
Tax increase: decreases disposable income of consumers
AD curve shifts left, both inflation and GDP decrease
Decrease in government spending: directly shifts the AD
curve left
Tools of Fiscal Policy
The two main tools of fiscal policy are taxes and spending.
Taxes influence the economy by determining how much
money the government has to spend in certain areas and
how much money individuals have to spend. For example, if
the government is trying to spur spending among
consumers, it can decrease taxes. A cut in taxes provides

families with extra money, which the government hopes

they will turn around and spend on other goods and
services, thus spurring the economy as a whole.

How does fiscal policy work?

When policymakers seek to influence the economy, they have
two main tools at their disposalmonetary policy and fiscal policy.
Central banks indirectly target activity by influencing the money
supply through adjustments to interest rates, bank reserve
requirements, and the sale of government securities and foreign
exchange; governments infl uence the economy by changing the
level and types of taxes, the extent and composition of spending,
and the degree and form of borrowing. Governments directly and
indirectly influence the way resources are used in the economy.
The basic equation of national income accounting helps show how
this happens: GDP = C + I + G + NX. On the left side is gross
domestic product (GDP)the value of all final goods and services
produced in the economy). On the right side are the sources of
aggregate spending or demandprivate consumption (C), private
investment (I), purchases of goods and services by the
government (G), and exports minus imports (net exports, NX).
This equation makes it evident that governments affect economic
activity (GDP), controlling G directly and influencing C, I, and NX
indirectly, through changes in taxes, transfers, and spending.
Fiscal policy that increases aggregate demand directly through an
increase in government spending is typically called expansionary
or loose. By contrast, fiscal policy is often considered
contractionary or tight if it reduces demand via lower spending.