Fiscal

Fiscal Policy

In order to learn and understand fiscal policy or monetary policy it is important to whether an economy, no matter where it may be in the world, can self regulate, or whether it needs an outside influence in order to adjust. This is where Classical and Keynesian economics will come into play. If you are of the Keynesian school of thought, you believe that the economy needs your influence in order to correct itself. This correction can be in the form of fiscal policy.

Fiscal policy can be defined as government�s actions to influence an economy through the use of taxation and spending. This type of policy is used when policy-makers believe the economy needs outside help in order to adjust to a desired point. Typically a government has a desire to maintain steady prices, an employment level, and a growing economy. If any of these areas are out of sorts, some type of fiscal policy may be in order.

Fiscal policy can be used in order to either stimulate a sluggish economy or to slow down an economy that is growing at a rate that is getting out of control (which can lead to inflation or asset bubbles). Fiscal policy directly affects the aggregate demand of an economy. Recall that aggregate demand is the total number of final goods and services in an economy, which include consumption, investment, government spending, and net exports.

Aggregate Demand = Consumption + Investment + Govt Spending + Net Exports

Fiscal policy has an effect on each of these categories. There are two types of fiscal policy: Expansionary and Contractionary.

Expansionary Fiscal Policy

When an economy is in a recession, expansionary fiscal policy is in order. Typically this type of fiscal policy results in increased government spending and/or lower taxes. A recession results in a recessionary gap � meaning that aggregate demand (ie, GDP) is at a level lower than it would be in a full employment situation. In order to close this gap, a government will typically...