Fiscal policy is the process the government uses to determine the appropriate level of taxes and spending necessary to deal with recessions, inflation, and unemployment. This is accomplished by the government deliberately making changes "
in either government spending or taxes to stimulate or slow down the economy" (Colander, 2004, p. 583). The methods used to accomplish such are identified as expansionary fiscal policy and contractionary fiscal policy. Expansionary fiscal policy can be used to bring an economy out of a recession, and contractionary fiscal policy can be used to reduce real output to fight inflation. The way these tools are used, as well as the possible need for their use in the current economy, will be discussed in further detail in the following pages. Expansionary Fiscal Policy
Expansionary fiscal policy is an increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output. The goal of expansionary fiscal policy is to close a recessionary gap, stimulate the economy, and decrease the unemployment rate. A good example of how expansionary fiscal policy works is through wars. During wars, government spending increases significantly, this causes a decrease in unemployment and a rise in the GDP. Unfortunately, this also causes an increase in the government deficit. World War II is a good illustration of the effect of expansionary fiscal policy. World War II
In 1940, the year before the United States entered the war, the U.S. unemployment rate was at 14.6 percent, the GDP was at $99 billion dollars, and the deficit was $-2.7 billion dollars. In 1941, with the bombing of Pearl Harbor and the entry of the United States into World War II, the federal government mobilized its resources and increased spending. This caused the deficit to increase to $-4.8 billion dollars, but also caused unemployment to drop to 9.9 percent and the GDP...
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