Fiscal Policy

By the end of this lesson, you will be able to explain the tools of fiscal policy, analyze the effects of expansionary and contractionary fiscal policy using the AD-AS model, and evaluate the limitations of fiscal policy.

What Is Fiscal Policy?

Fiscal policy refers to government decisions about spending and taxation used to influence economic output, employment, and price levels.

Who makes fiscal policy? The legislative and executive branches of government — Congress and the President in the U.S.

Contrast with monetary policy: Monetary policy is controlled by the central bank (Federal Reserve in the U.S.) through interest rates and the money supply. Fiscal policy is government spending and taxation.

The Tools of Fiscal Policy

Government spending (G): Direct spending on public goods, services, infrastructure, defense, and transfer payments (Social Security, Medicare, unemployment benefits).

Taxation (T): Collection of revenue through income taxes, corporate taxes, sales taxes, etc.

Net effect: GDP = C + I + G + (X - M); changing G directly affects GDP.

Expansionary Fiscal Policy

Used when the economy is in a recession (output below potential, high unemployment).

Goal: Shift aggregate demand (AD) to the right → increase output and employment.

Tools:

• Increase government spending: More G directly adds to AD
• Cut taxes: Less T → households have more disposable income → more consumer spending (C increases)
• Increase transfer payments: More money to low-income households who spend it quickly

Effect: AD shifts right → higher real GDP, lower unemployment; may cause some inflation.

Contractionary Fiscal Policy

Used when the economy is overheated (output above potential, high inflation).

Goal: Shift AD to the left → reduce inflationary pressure.

Tools:

• Decrease government spending: Less G → AD shifts left
• Raise taxes: More T → less disposable income → less consumer spending

Effect: AD shifts left → lower inflation; may increase unemployment slightly.

The Multiplier Effect