Fiscal policy is how a government uses spending and taxes to influence the economy. It matters because these choices can affect jobs, prices, business activity, public services, and household budgets. When the economy slows down, fiscal policy can help support demand.
When the economy overheats and inflation rises, fiscal policy can help cool spending.
Key Facts
- Fiscal policy uses two main tools: government spending and taxes.
- Expansionary fiscal policy increases aggregate demand by raising spending, cutting taxes, or both.
- Contractionary fiscal policy decreases aggregate demand by lowering spending, raising taxes, or both.
- Budget balance = tax revenue - government spending.
- Deficit = government spending - tax revenue, when spending is greater than revenue.
- Debt is the total amount the government owes from past borrowing, while a deficit is the shortfall in one year.
Vocabulary
- Fiscal policy
- Government action that uses spending and taxes to influence economic activity.
- Government spending
- Money the government pays for goods, services, public employees, infrastructure, benefits, and programs.
- Taxes
- Required payments collected by the government from individuals and businesses to fund public services and programs.
- Budget deficit
- A situation in which the government spends more money than it collects in tax revenue during a period.
- Aggregate demand
- The total spending on goods and services in an economy by consumers, businesses, government, and foreign buyers.
Common Mistakes to Avoid
- Confusing fiscal policy with monetary policy is wrong because fiscal policy is controlled by government spending and taxes, while monetary policy is controlled by the central bank through money supply and interest rates.
- Thinking tax cuts always increase government revenue is wrong because lower tax rates usually reduce revenue unless economic growth increases the tax base enough to offset the cut.
- Calling every deficit bad is too simple because a deficit may help during a recession, but persistent large deficits can raise debt and future interest costs.
- Assuming government spending affects only public workers is wrong because spending can flow to contractors, households, businesses, and local communities through the multiplier effect.
Practice Questions
- 1 A government collects 3.8 trillion in one year. Calculate the budget deficit or surplus.
- 2 A city government increases infrastructure spending by $500 million. If the spending multiplier is 1.6, estimate the total increase in economic output.
- 3 An economy has high inflation and very low unemployment. Explain whether the government should be more likely to use expansionary or contractionary fiscal policy, and identify one spending or tax action it could take.