Fiscal Policy

Fiscal policy refers to government actions taken to influence the economy, primarily government spending and taxation.

1. Government Spending: One aspect of fiscal policy involves government spending, or the government expenditures on goods and services such as infrastructure, education, healthcare, defense, and social welfare programs.

An increase in government spending is an increase in aggregate demand because government spending is one of the components of GDP (recall that GDP = C + G + I + NX). Thus, an increase in government spending decreases unemployment and raises prices, making it expansionary fiscal policy, used to boost the economy during times of economic downturns. However, an increase in government spending can also lead to the crowding-out effect, which will be discussed in a later module.

Conversely, a decrease in government spending is a decrease in aggregate demand, increasing unemployment and lowering prices. It is used to cool down the economy during times of economic highs, making it contractionary fiscal policy.