A demand shock can leave the economy in a gap. Fiscal policy is the government's use of spending and taxes to push aggregate demand back toward full employment. Its strength depends on the multipliers.
Key idea
Expansionary fiscal policy (more government purchases, lower taxes, or higher transfer payments) shifts AD right to close a recessionary gap. Contractionary fiscal policy (fewer purchases, higher taxes, lower transfers) shifts AD left to close an inflationary gap. In the United States, Congress and the President set fiscal policy.
Why it works
Government purchases are part of AD directly. Taxes and transfers change households' disposable income, and so consumption. In a recession, too little spending leaves workers and factories idle; adding spending (or leaving households more to spend) moves output toward potential. In an inflationary gap, the economy is straining; trimming spending eases the pressure on prices.
| Gap | Fiscal policy | AD | Real GDP | Price level | Unemployment |
|---|---|---|---|---|---|
| Recessionary | more G, lower taxes, more transfers | right | up | up | down |
| Inflationary | less G, higher taxes, fewer transfers | left | down | down | up |
Worked examples
Worked example: Choosing a policy
Unemployment is high and output is below potential. Which fiscal policies fit?
- This is a recessionary gap: AD must shift right.
- Raise government purchases, cut taxes, or raise transfer payments. Real GDP and the price level rise; unemployment falls.
Answer: Expansionary fiscal policy
Worked example: Purchases or transfers?
The government raises Social Security payments by \$30 billion. Is that an increase in G?
- No. Social Security checks buy no good or service: they are transfer payments.
- They raise households' income, so they work like a tax cut, through consumption, with the smaller tax-style multiplier.
Answer: No: a transfer, which works like a tax cut
Discretionary fiscal policy has practical limits: it takes time to see a recession, pass a law and spend the money, and a change may arrive after the economy has already recovered. How large fiscal multipliers are, and so how much a given change helps, is debated among economists.
Common mistake
Choosing a tax increase to fight a recession, or counting transfer payments as government purchases. A tax increase lowers spending, which deepens a recession. Transfers are not G; they work like a tax cut. Check: in a recessionary gap, every tool should push AD right.
See what federal spending pays for on Your Tax Receipt: enter an amount of federal income tax and get an itemized receipt of where it went.