Fiscal policy is the use of government spending and taxation by the central government to influence the level of aggregate demand (AD) in the economy. By altering the amount of money that households and firms receive (through taxes) or spend (through public expenditure), the government can try to achieve macro‑economic objectives such as:
Economic growth
Low unemployment
Price stability (control of inflation)
Equitable distribution of income
How Fiscal Policy Works
The basic mechanism can be expressed as:
\$\Delta AD = \Delta G + \Delta C + \Delta I - \Delta T\$
where:
\(\Delta G\) = change in government spending
\(\Delta C\) = change in consumption (affected by disposable income)
\(\Delta I\) = change in investment
\(\Delta T\) = change in taxes (reduces disposable income)
Key Instruments of Fiscal Policy
Instrument
Expansionary Effect
Contractionary Effect
Government spending (G)
Increase G → AD rises → higher output and employment
Decrease G → AD falls → lower output and employment
Direct taxes (e.g., income tax)
Decrease taxes → disposable income ↑ → consumption ↑ → AD rises
Increase taxes → disposable income ↓ → consumption ↓ → AD falls
Indirect taxes (e.g., VAT)
Decrease \cdot AT → prices of goods fall → consumption ↑ → AD rises
Increase \cdot AT → prices rise → consumption ↓ → AD falls
Types of Fiscal Stance
Expansionary fiscal policy: Used when the economy is in a recession. It involves increasing G or cutting taxes to boost AD.
Contractionary fiscal policy: Used when the economy is overheating or inflation is high. It involves decreasing G or raising taxes to reduce AD.
Limitations of Fiscal Policy
Time lags: Recognition, decision, and implementation lags can delay impact.
Political constraints: Governments may be reluctant to cut spending or raise taxes.
Crowding‑out effect: Higher government borrowing can raise interest rates, reducing private investment.
Impact on external sector: Large fiscal deficits may affect exchange rates and the balance of payments.
Suggested diagram: AD–AS model showing the right‑ward shift of AD after an expansionary fiscal policy and the left‑ward shift after a contractionary fiscal policy.