Introduction to Fiscal Policy: Videos & Practice Problems

Fiscal policy and monetary policy are two key tools used to influence a country's economy. Fiscal policy is managed by the government and involves adjusting government spending and taxation levels to impact the economy. For example, increasing government spending can boost GDP, while higher taxes can reduce disposable income and lower consumption. On the other hand, monetary policy is managed by the Federal Reserve (the Fed) and involves controlling the money supply and interest rates. The Fed might lower interest rates to encourage borrowing and investment or raise them to control inflation. Both policies aim to stabilize and grow the economy but operate through different mechanisms.

Government spending is a crucial component of GDP, which is calculated as the sum of consumption, investment, government spending, and net exports. When the government increases its spending, it directly boosts GDP because government expenditures are part of the GDP calculation. Conversely, when government spending decreases, GDP tends to fall. This relationship is straightforward: more government spending injects more money into the economy, leading to higher economic output, while less spending results in lower economic activity.

Automatic stabilizers are mechanisms in fiscal policy that automatically adjust government spending and taxes based on the business cycle without proactive government intervention. For example, during an economic boom, higher incomes lead to higher tax revenues, which can reduce disposable income and consumption, helping to cool down the economy. Conversely, during a recession, lower incomes result in lower tax revenues and increased unemployment benefits, which boost disposable income and consumption, helping to stimulate the economy. These automatic adjustments help stabilize economic fluctuations.

Taxes directly impact disposable income, which is the income left after taxes. Higher taxes reduce disposable income, leaving households with less money to spend on consumption. This decrease in consumption can lower overall economic activity. Conversely, lower taxes increase disposable income, giving households more money to spend, which can boost consumption and stimulate economic growth. Therefore, changes in tax policy can significantly influence consumer behavior and, consequently, the broader economy.

Discretionary fiscal policy involves deliberate actions by the government to influence the economy through changes in government spending and taxation. This type of policy requires proactive measures, such as passing new legislation to increase infrastructure spending or reduce taxes. For example, during a recession, the government might implement a stimulus package to boost spending and investment. Discretionary fiscal policy is distinct from automatic stabilizers, which adjust spending and taxes automatically based on economic conditions without new legislative action.