Fiscal Policy

Fiscal policy is the government changing how much it spends and how much it taxes in order to speed up or cool down the economy. In a recession, it might cut taxes so you keep more of your paycheck, or fund new roads and schools to get money flowing and people hired. When the economy is overheating and prices are rising too fast, it does the reverse — spending less or taxing more to take some heat out of demand.

More precisely, fiscal policy is the use of government spending ($G$) and taxation ($T$) to influence aggregate demand. Expansionary fiscal policy raises $G$ or cuts $T$ to boost demand in a downturn; contractionary fiscal policy cuts $G$ or raises $T$ to restrain demand when inflation is a threat. It is set by the legislature and treasury — which is what separates it from monetary policy, run independently by the central bank. Two effects shape how well it works: crowding out (government borrowing can raise interest rates and dampen private investment) and automatic stabilizers (taxes and benefits that adjust on their own as the economy moves).