Fiscal Policy

The word 'fiscal' means 'budget

a means by which a government adjusts its

spending levels and tax rates to monitor and
influence a nation's economy.

based on the theories of British economist

John Maynard Keynes

directly affects the aggregate demand of

an economy.
Fiscal Policy Tools
Government Spending
Taxes
Government Spending
includes
subsidies, transfer
payments including welfare
programs, public works projects,
and government salaries.

Byadjusting government spending,

the government can influence
economic output.
 Affectsbusinesses who sell the goods and
services bought by the government.

Effectof a single increase in government

spending leads to a much greater result -
an effect that economists call the
multiplier effect.
Taxes
Changes in taxes affect the average consumer's
income, and changes in consumption lead to
changes in real GDP.

Taxes can be changed in several ways:

Firstly, marginal tax rates can be raised or
lowered.
Secondly, they can be eliminated entirely, or the
tax rules can be modified.
Types of Fiscal Policy
ExpansionaryFiscal Policy
Contractionary Fiscal Policy
Expansionary Fiscal Policy
- increased government
spending and/or lower taxes

- used to combat a recession

Changes in government spending:

- A rise in expenditure causes an increase in aggregate

demand.
Expansionary Gap (Government Spending)

If there is a recessionary gap

in panel (a), fiscal policy can
presumably increase
aggregate demand
Changes in taxes:

- A decrease in taxes causes an increase in aggregate

demand.
Expansionary Gap (Taxes)

In panel (b) with a

recessionary gap (in this case
$500 billion) taxes are cut
AD1 moves to AD2
The economy moves from E1
to E2, and real GDP is now at
$12 trillion per year
Contractionary Fiscal Policy
- Opposite of expansionary fiscal policy

- government may reduce government

spending and increase taxes
Changes in government spending:

- A decrease in expenditure causes a decrease in

aggregate demand.
Contractionary Gap (Government Spending)

If there is an inflationary gap,

fiscal policy can presumably
decrease aggregate demand
Change in taxes:

- A rise in taxes causes a reduction in aggregate

demand.
Contractionary Gap (Taxes)

Contractionary fiscal policy can

move aggregate demand to
AD2 via a tax increase