Fiscal policy is the use of government spending and taxation to influence the economy. Governments use fiscal policy to influence the level of aggregate demand in the economy in an effort to achieve the economic objectives of price stability, full employment, and economic growth.
The government has two levers when setting fiscal policy:
- Change the level and composition of taxation, and/or
- Change the level of spending in various sectors of the economy.
There are three main types of fiscal policy:
- Neutral: This type of policy is usually undertaken when an economy is in equilibrium. In this instance, government spending is fully funded by tax revenue, which has a neutral effect on the level of economic activity.
- Expansionary: This type of policy is usually undertaken during recessions to increase the level of economic activity. In this instance, the government spends more money than it collects in taxes.
- Contractionary: This type of policy is undertaken to pay down government debt and to cap inflation. In this case, government spending is lower than tax revenue.
In times of recession, Keynesian economics suggests that increasing government spending and decreasing tax rates is the best way to stimulate aggregate demand. Keynesians argue that this approach should be used in times of recession or low economic activity as an essential tool for building the foundation for strong economic growth and working towards full employment . In theory, the resulting deficit would be paid for by an expanded economy during the boom that would follow.
Times of Recession
In times of recession, the government uses expansionary fiscal policy to increase the level of economic activity and increase employment.
In times of economic boom, Keynesian theory posits that removing spending from the economy will reduce levels of aggregate demand and contract the economy, thus stabilizing prices when inflation is too high.