In economics and political science, fiscal policy is the use of government revenue collection (taxation) and expenditure (spending) to influence the economy. The two main instruments of fiscal policy are changes in the level and composition of taxation and government spending in various sectors. These changes can affect the following macroeconomic variables in an economy: Aggregate demand and the level of economic activity;
The distribution of income;
The pattern of resource allocation within the government sector and relative to the private sector. There are three major ways in which fiscal policy affects aggregate demand: 1.Business Tax Policy - Business taxes can change the profitability of businesses and the amount of business investment. Lowering business taxes will increase aggregate demand and business investment spending. 2.Government Spending - Government can directly increase aggregate demand by increasing its spending. 3.Tax Policy for Individuals - Lowering taxes will increase disposable personal income and increase consumption spending. In order to learn and understand fiscal policy or monetary policy it is important to whether an economy, no matter where it may be in the world, can self regulate, or whether it needs an outside influence in order to adjust. This is where Classical and Keynesian economics will come into play. If you are of the Keynesian school of thought, you believe that the economy needs your influence in order to correct itself. This correction can be in the form of fiscal policy. Fiscal policy can be defined as government’s actions to influence an economy through the use of taxation and spending. This type of policy is used when policy-makers believe the economy needs outside help in order to adjust to a desired point. Typically a government has a desire to maintain steady prices, an employment level, and a growing economy. If any of these areas are out of sorts, some type of fiscal policy may be in order. Fiscal policy can be used in order to either stimulate a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control (which can lead to inflation or asset bubbles). Fiscal policy directly affects the aggregate demand of an economy. Recall that aggregate demand is the total number of final goods and services in an economy, which include consumption, investment, government spending, and net exports. Aggregate Demand = Consumption + Investment + Govt Spending + Net Exports Fiscal policy has an effect on each of these categories. There are two types of fiscal policy: Expansionary and Contractionary.
Expansionary Fiscal Policy
When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap – meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically increase their spending which will directly increase the aggregate demand curve (since government spending creates demand for goods and services). At the same time, the government may choose to cut taxes, which will indirectly affect the aggregate demand curve by allowing for consumers to have more money at their disposal to consume and invest. The actions of this expansionary fiscal policy would result in a shift of the aggregate demand curve to the right, which would result closing the recessionary gap and helping an economy grow.
Contractionary Fiscal Policy
Contractionary fiscal policy is essentially the opposite of expansionary fiscal policy. When an economy is in a state where growth is at a rate that is getting out of control (causing inflation and asset bubbles), contractionary fiscal policy can be used to rein it in to a more sustainable level. If an economy is growing too fast or for example, if unemployment is...
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