What Is Fiscal Policy?

National, state, and local governments set a fiscal policy, which is government intervention in the economy through spending and tax policies. Fiscal policy involves various measures taken by the government that intervene with the economy. Aggregate demand (AD) is the total demand for final goods and services in an economy at a given time: $\text{AD}=\text{C}+\text{I}+\text{G}+(\text{X}-\text{M})$ , where C is consumption, I is investments, G is government spending, and $(\text{X} - \text{M})$ is net exports (exports minus imports). Consumption is the purchase of goods and services by households. Government spending is money spent by the government for various government programs. Fiscal policy aims to influence aggregate demand by affecting consumption and government spending. Lawmakers possess the power to change the rates of government spending and taxation (which affects consumption), and these changes could have large and immediate implications on the wider economy.

The goal of fiscal policy with regard to economics is to either stimulate the economy or slow it down. There are two main tools of fiscal policy: government spending and tax rates.

Governments can intervene directly in the economy by increasing or decreasing their purchases, a fiscal policy tool called government spending. If the economy is in a recession, two successive quarters during which gross domestic product decreases, the government may want to boost aggregate demand. Therefore, the government may decide to build new bridges and roads in different states; infrastructure spending keeps jobs and economic growth within specific regions. Construction industries react to this new demand by increasing production. To increase production, manufacturers (such as those who produce steel, forklifts, and other materials necessary for construction) may need to hire more workers or pay higher wages to employees with specialized skills. Furthermore, manufacturers must purchase raw materials and, perhaps, upgrade their factories. Government purchases of this kind stimulate demand throughout the wider economy and can be shown as an outward shift in the aggregate demand curve.

Conversely, a decrease in government purchases has the opposite effect. For example, if the economy is expanding rapidly, the government might reduce spending on programs for the unemployed. In theory, fewer people will need these programs when the economy is booming because fewer people will be unemployed. The effect of reduced government spending is an inward shift of the aggregate demand curve. Although government spending will have a positive impact on the economy, the magnitude of the impact cannot be accurately predicted due to the multiplier effect (the additional effect on the economy or gross domestic product from a change in government spending or investment) and crowding out, an effect whereby government spending causes the interest rate (cost of borrowing money, expressed as a percentage of the amount borrowed, or, equivalently, the return on savings) to rise and investment to fall.

Governments can also affect economic activity by changing tax policies. The government raises revenue through a variety of taxes, and changing the rates of these taxes can affect the economy in different ways. For instance, lowering personal income taxes increases household income, which in turn promotes consumer spending. Lowering corporate tax rates is intended to promote business investment and growth. The effects of changes to the tax rate are also influenced by the multiplier and crowding-out effects. In addition, the effects of changes to tax rates are influenced by the public's perception of how permanent the changes will be.