Fiscal policy uses changes in taxes and government spending to influence the economy and meet the macro aims.
Fiscal policy is the use of taxes and government spending to change how the economy performs. The government decides it, usually in the yearly budget.
Expansionary fiscal policy means cutting taxes or raising government spending. Total demand rises. Firms sell more and hire more workers, so output grows and fewer people are out of work. It is used in a recession.
Contractionary fiscal policy means raising taxes or cutting spending. Total demand falls, which slows rising prices caused by too much spending. It may also cut a budget deficit.
Fiscal policy can serve other aims too. Progressive taxes and welfare payments spread income more fairly. Spending on schools and transport raises output per worker over time. Taxes on pollution protect the environment. But changes take time to plan and to work, and a deficit must be paid for by borrowing.
- Fiscal policy
- Changes in taxes and government spending.
- Expansionary
- Lower taxes / higher spending; for recession and unemployment.
- Contractionary
- Higher taxes / lower spending; for inflation.
Worked example: Fiscal policy in a recession
Suppose unemployment is rising because households and firms are spending less.
- Policy: the government raises spending on public housing and roads and cuts income tax.
- Total demand rises: construction firms get orders, and households have more to spend.
- Firms produce more and hire more workers, so unemployment falls and growth recovers.
- Possible costs: a larger budget deficit, and inflation if demand rises too fast.
Watch out for this
Fiscal policy is when the central bank changes interest rates.
Changing interest rates is monetary policy, run by the central bank. Fiscal policy is the government changing taxes and its own spending.
Check your understanding
A government wants to reduce high inflation caused by too much spending. Which fiscal policy fits?
- Raise taxes and cut government spending
- Cut taxes and raise government spending
- Lower interest rates