3.8 Fiscal Policy

What is Fiscal Policy?

Fiscal policy is the use of government spending and taxation to influence aggregate demand and stabilize the economy. Expansionary fiscal policy (increased spending, decreased taxes) is used to fight recessions by shifting AD right. Contractionary fiscal policy (decreased spending, increased taxes) fights inflation by shifting AD left. Congress and the President enact fiscal policy.

Multiplier Effects

Government spending changes have a direct effect on AD equal to the full amount spent, multiplied by the spending multiplier (1/MPS). Tax changes only affect AD indirectly through consumption, so they use the smaller tax multiplier (MPC/MPS). This means a $1 spending increase shifts AD more than a $1 tax cut.

Deficits, Surpluses, and Debt

A budget deficit occurs when government spending exceeds tax revenue in one year; a surplus is the opposite. Accumulated deficits over time create the national debt. Expansionary policy tends to increase deficits/debt, while contractionary policy can reduce them, though these tools have tradeoffs with future fiscal flexibility and crowding out.

Key terms

Fiscal Policy

Government use of spending and taxation to influence aggregate demand and stabilize the economy.

Expansionary Fiscal Policy

Increased government spending and/or decreased taxes to shift AD right and fight recession.

Contractionary Fiscal Policy

Decreased government spending and/or increased taxes to shift AD left and fight inflation.

Spending Multiplier

1/MPS; measures the direct, full impact of a change in government spending on AD.

Tax Multiplier

MPC/MPS; measures the smaller, indirect impact of a tax change on AD (since part is saved).

Try an AP-style question

Which is expansionary fiscal policy?

1. Raising taxes
2. Cutting taxes
3. Cutting spending
4. Selling bonds by the Fed