Fiscal policy addresses changes in the allocation and levels of economic resources and is generally associated with the economic theory of John Maynard Keynes, also called Keynesian Theory.
Fiscal policy includes government budget decisions regarding federal spending, money raised by the government through taxes and budget deficits or surpluses. By adjusting overall demand for goods and services through changes in taxation and government spending, the government hopes to control unemployment levels and inflation, which adversely affect the economy's health.
Fiscal policy can be either expansionary or contractionary:
- Expansionary fiscal policy is appropriate when the economy is operating below its normal output, as in recessions and troughs in the business cycle when unemployment is high, business profits are low and businesses are not operating at full capacity. Government spending will be increased and/or taxes for individuals (and perhaps small businesses) will be reduced to stimulate the economy.
- Contractionary fiscal policy occurs when the business cycle is near its peak, businesses are at full capacity, unemployment is low and business profits are high. The government decreases spending and may increase taxes for individuals and businesses. A government will often wipe out its deficit and create a surplus during a contractionary fiscal period.
Learn more about how governments adjust taxes and government spending to moderate the economy in the article: What is Fiscal Policy?
Economic Activity and Taxes
All of the factors discussed in this section, from inflationary pressures to Fed actions, will affect the level of economic activity. When businesses and individuals have easier access to credit, they will expand their operations and consume more goods respectively, and stimulate the overall growth and activity of the economy. Conversely, when the credit environment is unfriendly towards businesses and consumers and the price of goods rises because supplies are limited, manufacturing activity contracts and economic growth slow down.
Lower tax rates can stimulate spending by leaving more money in the hands of consumers and businesses. The opposite is true for raising tax rates: less money stays in the pockets of businesses and consumers alike, resulting in a decline in economic activity.
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