Fiscal Policy: Changes in Government Spending or/and Tax collections to (1) stimulate economy or (2) control inflation

• Discretionary (active): Changes in Government Spending and Taxes are dependent on the Federal Government.
• Non-Discretionary (passive/automatic): Changes are not initiated through congressional action.

Aims:

• Full Employment.
• Control inflation.
• Encourage Economic Growth.

The following fiscal policies defined here are discretionary, meaning they are at the option of the Federal government, often the Council of Economic Advisers (CEA).
Expansionary fiscal policy: helps an economy out of recession and to reduce unemployment

• Increase government spending (the most direct method)
  • before the government spending increase : GDP↓, PL ↓
  • after the increase in government spending : G ↑ → AD ↑ → GDP ↑, PL ↑, UE ↓
    
• Tax reduction
  • before the tax reduction : GDP↓, PL ↓
  • after the tax reduction : T ↓ → DI ↑→ C↑→ AD ↑ → GDP ↑, PL ↑, UE ↓
    
• Combination of both to achieve greater effects, but by themselves, government spending leads to a higher level of GDP.

Result: Expansionary Fiscal Policy creates budget deficit (Government Spending > Tax Revenues), thus, shifting the graph to the right.
Contractionary fiscal policy: reduces demand-pull inflation (demand shifts out so PL increase, Real GDP increase), usually applied when the economy is experiencing over-employment). Designed to deal with inflation.

• Increase tax
  • before the tax increase : PL↑, Real GDP ↑
  • after the tax increase : T ↑ → DI ↓ --> C↓ → AD ↓ → GDP ↓, PL ↓, UE ↑
    
• Decrease government spending
  • before the government spending: PL↑, Real GDP ↑
  • after the government spending: G ↓ → AD ↓ → GDP ↓, PL ↓, UE ↑
    
• Combination of both to achieve greater effects

Result: Contractionary Fiscal Policy creates budget surplus (Tax Revenues > Government Spending), thus, shifting the graph to the left.
Policy options: G or T?

• Economists who support government expansion (in other words, maintain its size) believe:
  • Increased government spending during recessions
  • Tax increases during demand-pull inflation
• Economists who want to reduce or contain the government believe:
  • Tax cuts during recessions
  • Reduced government spending during times of demand-pull inflation
  

NOTE: Since the actual economy is not as simple and tidy as it is in theory, the declines in output do not push the price level downward but rather halter the rise of the price level from continual increase.


Discretionary fiscal policy is the purposeful change of government expenditures and tax collections by government to promote full employment, price stability, and economic growth.