What do you mean by Fiscal policy?
Fiscal policy is the use of taxes, government transfers, or government purchases of goods and services to shift the aggregate demand curve.
Discretionary Fiscal Policy: government takes deliberate actions through legislation to alter spending or taxation policies
Expansionary Fiscal Policy:
When the economy is in recession, government wants to increase AD
Tax cut: increases consumers disposable income
o Increases AD as long as consumers don’t increase savings or spending on imports
Increase in government spending: directly shifts the AD curve
Contractionary Fiscal Policy When economy is suffering from inflation, government wants to decrease AD
Tax increase: decreases disposable income of consumers
o AD curve shifts left, both inflation and GDP decrease
Decrease in government spending: directly shifts the AD curve left
Fiscal Policy and the Multiplier:
Fiscal policy has a multiplier effect on the economy.
Expansionary fiscal policy leads to an increase in real GDP larger than the initial rise in aggregate spending caused by the policy.
The government spends an additional $4 Billion through discretionary fiscal policy. The total effect on GDP will be larger than $4 Billion.
The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.
Conversely, contractionary fiscal policy leads to a fall in real GDP larger than the initial reduction in aggregate spending caused by the policy.
Tools of Fiscal Policy:
Changes in government spending:
Can increase spending in normal budgetary programs (health, education, welfare, etc.)
Can increase spending on infrastructure (underlying economic foundation of goods and services that allows a society to function e.g. build roads, schools, communication systems) o
Added advantage of increasing capital goods in economy which can shift AS in the future
Changes in taxation:
Raise or lower personal and corporate income taxes and/or sales and excise taxes
Alter tax exemptions or tax credits
Provide special tax incentives for investment (Capital Cost Allowance)