Fiscal Policy Definition, Types, and Examples

Avery Gordon, Jon Nash, Lesley Chapel
  • Author
    Avery Gordon

    Avery Gordon has experience working in the education space both in and outside of the classroom. He has served as a social studies teacher and has created content for Ohio's Historical Society. He has a bachelor's degree in history from The Ohio State University.

  • Instructor
    Jon Nash

    Jon has taught Economics and Finance and has an MBA in Finance

  • Expert Contributor
    Lesley Chapel

    Lesley has taught American and World History at the university level for the past seven years. She has a Master's degree in History.

Learn about fiscal policy tools and how they impact the economy. Study fiscal policy examples, such as taxes, government spending, and transfer payments. Updated: 11/20/2021

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What Are the Tools of Fiscal Policy?

A government uses fiscal policy to achieve the macroeconomic goals of price stability and total employment output to have a stable, growing economy. Over time a nation's economy fluctuates and can be in one of three states:

  • Recessionary gap: A recessionary gap is when the economy is struggling, experiencing price level deflation, production of goods and services below its potential output, and high unemployment.
  • Full employment output: Full employment output, also called potential output, represents a healthy economy producing at its expected potential given its resources and population.
    • It is important not to confuse full-employment output and everyone being employed. Instead, it means it is a minimum level of unemployment that is sustainable.
  • Inflationary gap: An inflationary gap is when the economy is overheated, producing at an unsustainable level and causing inflation.

The government can use three main tools to help an economy experiencing either a recessionary gap or inflationary gap to return it to full employment output. These tools are changing the tax rate and the level of government spending and altering government transfers. When any of these tools are used, the goal is to increase or decrease aggregate demand, closing a recessionary or inflationary gap.

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  • 0:05 Fiscal Policy Tools…
  • 2:06 Government Spending
  • 3:31 Taxes
  • 4:10 Transfer Payments
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Understanding Fiscal Policy Tools

When addressing a recessionary or inflationary gap in the economy, the government uses the same three tools but different ways. For instance, when changing the tax rate, the government would lower it when dealing with a recessionary gap to promote consumer spending or raise during an inflationary gap to discourage spending. The opposite is true for government spending, an increase helps a recessionary economy, and a decrease can fix an inflationary economy.

The last tool is altering government transfers which include programs like welfare and social security. An increase in government transfers helps with a recessionary economy, and a decrease is used in an inflationary economy.

Government Spending

Government spending is one fiscal policy tool and occurs when the government spends money purchasing goods and services, affecting aggregate demand for those goods and services. When aggregate demand goes up, so does output to meet the new level of demand and prices. The opposite is true when aggregate demand is decreased. Below is an example of how government spending can influence the economy:

The United States is in a recessionary gap; one way to fix this gap would be by increasing spending. To do this, congress decides to spend more on fixing the country's infrastructure by improving highways and replacing lead pipes.

First, the government would have to purchase the necessary resources to complete those projects, such as the copper needed for the new pipes. The new need for these resources increases aggregate demand in the economy. Output goes up to meet the government needs, and so does price because firms can now charge more since their products are in higher demand. Employment rises because firms producing copper and other materials need to hire more employees to match the new demand. Additionally, the government will need to hire contractors to do the roadwork and replace the pipes.

So by increasing government spending, the U.S. increased its aggregate demand taking it out of a recessionary economy with the added benefit of improved infrastructure. However, if there were an inflationary gap, the government would do the opposite and reduce government spending, lowering aggregate demand.

These results from this example can be examined on the following graph:


Aggregate demand rises due to increased government spending. Taking the economy from an inflationary gap at AD1 back to full employment output at AD2

Aggregate Demand increase

Taxes

Taxes are another fiscal tool the government has at its disposal. By altering taxes, the government can increase or decrease different types of spending. For example, if the United States was in an inflationary gap where the economy was overheated, it could raise income taxes. By raising income taxes, households now have less money to spend, therefore reducing consumer spending. Consumer spending, just like government spending, affects aggregate demand.

A reduction in spending lowers demand because fewer people are buying goods. This reduction means that firms will lower their output, so they do not overproduce relative to the new level of demand; they will also lower prices to encourage people to buy their products. This change can be seen in the following graph:


Aggregate demand decreasing due to the rise income taxes which lowers consumer spending

Aggregate demand decreasing

There are other types of taxes the government could change, like corporate taxes. Suppose the economy was in a recessionary gap. In that case, they could lower corporate taxes to spend those savings on re-investing in their company, such as improving company products or expanding to new locations. This practice is called investment spending, and just like both consumer and government spending, it has a similar effect on aggregate demand.

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Prompts About Fiscal Policy Tools:

Definition Prompt:

Define fiscal policy in your own words in approximately two to three sentences.

Hint: Fiscal policy can influence the GDP.

Essay Prompt 1:

Write an essay of approximately three to four paragraphs that explains government spending as a fiscal policy tool. Be sure to answer the following question: How does government spending influence economic output?

Example: The money that businesses earn from government spending can result in the need for more employees, and those employees can stimulate the economy by spending a portion of their wages.

Essay Prompt 2:

In one to two paragraphs, write an essay that explains how taxes can be used as a fiscal policy tool.

Example: Tax rates can be raised or lowered.

Essay Prompt 3:

In approximately two to three paragraphs, write an essay that describes transfer payments as a fiscal policy tool. Be sure to answer the following question: How are transfer payments similar to taxes as a fiscal policy tool?

Example: Transfer payments include things like Social Security payments, and they can alter people's incomes and spending power.

Graphic Organizer Prompt:

Create a poster, chart, or other type of graphic organizer that compares and contrasts expansionary fiscal policy and contractionary fiscal policy.

Example: Contractionary fiscal policy can be used to curb inflation, while expansionary fiscal policy can be used to increase aggregate demand.

What is considered fiscal policy?

A government uses fiscal policy to achieve the macroeconomic goals of price stability and full employment output to have a stable, growing economy. The tools used to implement fiscal policy are changing tax rates, changing government spending, and altering government transfers.

What are the 3 tools of fiscal policy?

The government can use three main tools to help an economy experiencing either a recessionary gap or inflationary gap to return it to full employment output. These tools are:

  • Changing the tax rate
  • Changing the level of government spending
  • Altering government transfers

When any of these tools are used, the goal is to increase or decrease aggregate demand, closing a recessionary or inflationary gap.

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