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.

How Fiscal Policy works?

Scenario one: High rate of Inflation

High rate of inflation is caused by too much aggregate demand in the economy. Government will use deflationary fiscal policy. Government will try to influence aggregate demand by reducing its public spending. The government will spend less on construction of roads, bridges and other public spending and thus aggregate demand will fall. On the other hand, Government may increase the tax rates. An increase in tax rates will take away the extra disposable income out people’s pocket resulting in a lower demand.



Scenario two: Low rate of Inflation

In an economic recession, aggregate demand, output and employment all tend to fall. Now the Government wants to increase employment in the economy, it can attempt to do so by increasing aggregate demand. The Government will increase the public spending resulting in a rise in aggregate demand. Government may reduce the tax rates so that people have more disposable income to spend and instigate demand in the economy.



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