Definition of fiscal policy. Fiscal policy involves the government changing the levels of taxation and government spending in order to influence Aggregate Demand (AD) and the level of economic activity.
- AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)
The purpose of Fiscal Policy
- Stimulate economic growth in a period of a recession.
- Keep inflation low (UK government has a target of 2%)
- Basically, fiscal policy aims to stabilise economic growth, avoiding a boom and bust economic cycle.
Fiscal policy is often used in conjunction with monetary policy. In fact governments often prefer monetary policy for stabilising the economy.
Expansionary (or loose) Fiscal Policy
- This involves increasing AD.
- Therefore the government will increase spending (G) and / or cut taxes (T). Lower taxes will increase consumers spending because they have more disposable income (C)
- This will tend worsen the government budget deficit and the government will need to increase borrowing.
