APMacro: Fiscal Policy

When significant changes in aggregate demand plunge our economy into recession or drive it into runaway inflation, fiscal policy allows policymakers to use changes in taxes and government spending to correct economic instability.

During a recession, aggregate demand falls, creating a recessionary gap which reduces output and employment. The government can use expansionary fiscal policy, reducing taxes, increasing government spending, or both to stimulate aggregate demand and restore the economy to full employment output. Expansionary fiscal policy creates a budget deficit, as the government spends more than its revenue in a year, and such deficits add to the national debt.

The government uses contractionary fiscal policy to combat inflation, raising taxes, reducing government spending, or both. Because of the ratchet effect, prices that rise tend not to fall to their previous levels, so the focus is on halting the rise of inflation and reducing aggregate demand to reduce further pressure on prices. The rise in tax revenue and fall in government spending would reduce the deficit or even cause a budget surplus, which would reduce the national debt.