Question

Explain the tools of government spending and tax policy as they relate to fiscal policy

Answer 1

The government fiscal policy consists of 2 major tools - Government spending and Tax policy.

1. Expansionary fiscal policy:

If an expansionary fiscal policy is carried out, then the government will either increase government spending or decreases taxes in order to increase the aggregate demand in the economy.

The equation of aggregate demand is given by: Y = C + I + (G-T) + (X-M)

where Y = output, C = consumption, I = investment, G = government spending, T = taxes, X = exports and M = imports.

Since G has a positive impact on output and T has a negative impact (it has a negative sign), thus, increasing aggregate output via expansionary fiscal policy will entail either an increase in G or a fall in T.

2. Contractionary fiscal policy:

On the otherhand, to decrease aggregate output, the government should either reduce spending or increase taxes or a mix of both.