Fiscal Policy
What is Fiscal Policy?
Fiscal policy is the government's use of spending and taxation to influence aggregate demand and the economy.
Expansionary fiscal policy (more spending or lower taxes) shifts aggregate demand right to fight a recession; contractionary fiscal policy does the reverse to cool inflation. It is set by the legislature and executive, not the central bank. Its impact is amplified by the spending and tax multipliers but weakened by crowding out and time lags.
Fiscal Policy: a worked example
Suppose an economy has a recessionary gap of $400 billion and the marginal propensity to consume is 0.75. The spending multiplier is 1 ÷ (1 − 0.75) = 4, so an increase in government purchases of $100 billion closes the gap, because $100 billion × 4 = $400 billion. Closing the same gap with a tax cut takes more, because the tax multiplier has size MPC ÷ (1 − MPC) = 0.75 ÷ 0.25 = 3, so taxes would have to fall by about $133 billion to produce the same $400 billion of extra aggregate demand.
The mistake students make with fiscal policy
Students apply the spending multiplier to a tax cut and conclude that cutting taxes by $100 billion with an MPC of 0.75 raises aggregate demand by $400 billion. It does not, because households save part of any tax cut: only MPC × $100 billion = $75 billion is spent in the first round, so the total effect is $75 billion × 4 = $300 billion. At the same MPC, a dollar of government purchases always moves aggregate demand more than a dollar of tax cuts.
Fiscal Policy questions
Who controls fiscal policy in the United States?
Fiscal policy in the United States is controlled by Congress and the President, who write the spending and tax laws, not by the Federal Reserve. The Federal Reserve controls monetary policy, which works through the money supply and interest rates instead.
What fiscal policy should be used during a recession?
During a recession the appropriate fiscal policy is expansionary: the government increases spending or cuts taxes to shift aggregate demand right, raising real GDP and lowering unemployment. The costs are a larger budget deficit and upward pressure on the price level.
Why is fiscal policy slower to work than monetary policy?
Fiscal policy is slower to work than monetary policy because a change in government spending or taxes must be recognized, debated and passed into law before it reaches the economy, while a central bank can change policy at a single scheduled meeting. Economists call these delays the recognition, administrative and operational lags.
Formula / Example
This is the live Fiscal Policy sandbox. Drag the curves, or open the full version.
Related terms
Common comparisons
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