Fiscal policy involves the Government changing the levels of Taxation and Govt Spending in order to influence Aggregate Demand (AD) and therefore the level of economic activity.
AD is the total level of planned expenditure in an economy (AD = C+ I + G + X – M)
The purpose of Fiscal Policy:
Reduce the rate of inflation, (UK government has a target of 2%)
Stimulate economic growth in a period of a recession.
Basically, fiscal policy aims to stabilise economic growth, avoiding the boom and bust economic cycle.
This refers to whether the govt is increasing AD or decreasing AD
Expansionary (or loose) Fiscal Policy.
This involves increasing AD,
Therefore the govt will increase spending (G)
and cut taxes. Lower taxes will increase consumers spending because they have more disposable income(C)
This will worsen the govt budget deficit
Deflationary (or tight) Fiscal Policy
This involves decreasing AD
Therefore the govt will cut govt spending (G)
And or increase taxes. Higher taxes will reduce consumer spending (C)
This will lead to an improvement in the government budget deficit
Fine Tuning : This involves maintaining a steady rate of economic growth through using fiscal policy. However this has proved quite difficult to achieve precisely.
Automatic Fiscal Stabilisers
If the economy is growing, people will automatically pay more taxes ( VAT and Income tax) and the Government will spend less on unemployment benefits. The increased T and lower G will act as a check on AD.
In a recession the opposite will occur with tax revenue falling but increased government spending on benefits, this will help increase AD
Discretionary Fiscal Stabilisers
This is a deliberate attempt by the govt to affect AD and stabilise the economy, e.g. in a boom the govt will increase taxes to reduce inflation
Injections (J): This is an increase of expenditure into the circular flow, it includes govt spending(G), Exports (X) and Investment (I)
Withdrawals (W): This is leakages from the circular flow This is household income that is not spent on the circular flow. It includes: Net savings (S) + Net Taxes (T) + Net Imports (M)
Note Fiscal Policy was particularly used in the 50s and 60s to stabilise economic cycles. These policies were broadly referred to as 'Keynesian' In the 1970s and 80s governments tended to prefer monetary policy for influencing the economy.
There are many factors which make successful implementation of fiscal Policy difficult.