What Is Fiscal Policy?
Fiscal policy refers to the government's use of taxation and public spending to influence the economy. It aims to achieve macroeconomic goals like full employment, price stability, and sustainable growth. Unlike monetary policy, which is managed by central banks, fiscal policy is set by elected officials through budgets and legislation.
Key Components of Fiscal Policy
The main tools are expansionary policy, which increases government spending or cuts taxes to stimulate demand during recessions, and contractionary policy, which reduces spending or raises taxes to cool an overheating economy. These actions affect aggregate demand, influencing output, employment, and inflation levels.
Practical Example: Fiscal Policy in Action
During the 2008 financial crisis, the U.S. government implemented expansionary fiscal policy through the American Recovery and Reinvestment Act, injecting over $800 billion in spending on infrastructure and tax cuts. This boosted consumer and business spending, helping GDP recover from a sharp decline and averting a deeper recession.
Effects on GDP and Real-World Applications
Fiscal policy impacts GDP by altering aggregate demand: expansionary measures increase GDP in the short term via the multiplier effect, where initial spending generates further economic activity. However, excessive use can lead to higher debt or inflation. In developing economies, it's crucial for infrastructure investment to drive long-term GDP growth, while in advanced ones, it's used to counter business cycles.