• thinkigcse.com

The role of fiscal policy

Fiscal policy refers to government policy that attempts to influence the direction of the economy through changes in government taxes or through some spending.

The two main instruments of fiscal policy are government spending and taxation.

Changes in the level and composition of taxation and government spending can impact on the following variables in the economy:

  • Aggregate demand and the level of economic activity.
  • The pattern of resource allocation.
  • The distribution of income.

AD=C+G+I+(X-M)

As we can see in the above equation that G (Government Expenditure) is a component of AD, it can be used by Government to influence AD in the economy. The government can use expansionary or deflationary fiscal policy to get the desired results. Let’s discuss each policy in detail.

Expansionary fiscal policy

Expansionary fiscal policy is used to increase the Aggregate demand in the economy. If the economy is having a deflationary gap, the government can use expansionary fiscal policy to reduce the gap or totally eliminate it.

Now, what is deflationary gap?

Deflationary gap is the difference between full level of employment and the actual level of output of the economy. We can see in the diagram below, that the economy is operating a level ‘a’ below the Yf (full level of employment).

deflationary gap

The consequence is that due to deflationary gap all the resources of the economy are not being used in the optimum level and they are idle. This results in unemployment and low level of output. This is not desirable for any government. In order to reduce/eliminate the deflationary gap, the government uses expansionary fiscal policy.

Government will either increase its spending or reduce taxes (or both) in order to stimulate the aggregate demand. Increase Government spending will result me more projects being funded by the government and thus employment and output will increase. Even a lower tax rate will result in more disposable income for households and encourage consumption.

Increased G and C will lead to higher AD. However, this might also lead to higher prices/inflation in the economy.

Contractionary fiscal policy

Contractionary fiscal policy involves the reduction of government spending and increase taxes as a measure to control inflation/AD in the economy. With reduced government spending, the AD will fall and thus reduce pressure on the economic resources and the average price level in the economy will come down. Similarly, increased taxes will take away the excess disposable income from the households and result in a fall in AD. Contractionary fiscal policy is thus used to reduce the inflationary gap.

But, what is inflationary gap?

Inflationary gap is when the Aggregate demand exceeds the productive potential of the economy. As we can see through the diagram, the economy is operating at a level above the full employment level of the output. Due the limitation of the economy to fulfil this increased demand the average price level in the economy increases resulting in inflation.

inflationary gap

In this case the government can use contractionary fiscal policy to control inflation and bring down the AD.

 

Watch a Video

Exciting News!

IMPORTANT MESSAGE

Quizzes and worksheets on this website have been developed in Flash format. Flash is no more supported by browsers. Therefore, you might see blank pages on some instances. Install Flash player plugin for Chrome from Chrome Web Store. Click here 

Similarly, for other web browsers you will have to activate the relevant flash player plugins.

JOIN OUR ONLINE COURSES

New Youtube Channel - ThinkIGCSE

Hi Everyone, I have launched a new YouTube channel with more than a 100 videos on  Economics and Business Studies, tailored specifically for IGCSE and A Level and IBDP students.

Subscribe now and join us on this learning journey: @thinkIGCSE

WHO'S ONLINE

We have 108 guests and no members online

Crosswords

PDF FILE

Download

MindMaps

PDF FILE

Download

Save
Cookies user preferences
We use cookies to ensure you to get the best experience on our website. If you decline the use of cookies, this website may not function as expected.
Accept all
Decline all
Read more
Analytics
Tools used to analyze the data to measure the effectiveness of a website and to understand how it works.
Google Analytics
Our website uses Google Analytics to understand how you interact with our site and improve your browsing experience. These cookies collect information in an anonymous form, including the number of visitors to the site, where visitors have come from, and the pages they visited. The data helps us analyze trends and user behavior to enhance our website's functionality and content.
Accept
Decline
Marketing
Set of techniques which have for object the commercial strategy and in particular the market study.
Marketing
Our website uses Google marketing cookies to deliver personalized ads and measure the effectiveness of our advertising campaigns. These cookies track your online activity to help us show you relevant ads on Google services and partner websites.
Accept
Decline