Fiscal policy refers to the government’s use of taxation and public expenditure to influence the aggregate demand and overall direction of the national economy.
Types of Fiscal Stances
Depending on the current state of the business cycle, the government will deploy one of two primary fiscal strategies:
- Expansionary Fiscal Policy: Deployed during an economic recession or slowdown. The government increases public spending, cuts tax rates, or does both. This injects money into the economy, boosts consumer spending, encourages business investment, and creates jobs.
- Contractionary Fiscal Policy: Deployed when an economy is overheating and experiencing high inflation. The government cuts public expenditure or increases taxes. This reduces aggregate demand, cooling down economic activity to stabilize prices.
Automatic Stabilizers vs. Discretionary Policy
- Automatic Stabilizers: Structural features of the tax and welfare system that naturally react to economic shifts without needing new laws. For example, during a recession, progressive income tax collections naturally drop because people earn less, while unemployment benefit payments rise, keeping cash flowing through the economy.
- Discretionary Fiscal Policy: Deliberate, real-time interventions by lawmakers to pass new tax rates or launch specific infrastructure spending bills to correct an economic imbalance.
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