Fiscal policy refers to the government's use of taxation and spending to influence the overall economy. It is set by legislatures and executive branches, distinguishing it from monetary policy, which is conducted by central banks. Expansionary fiscal policy involves increasing government spending and/or cutting taxes to stimulate aggregate demand, typically deployed during recessions to boost output and employment. Contractionary fiscal policy moves in the opposite direction, reducing spending and/or raising taxes to cool an overheating economy and dampen inflationary pressure.
When government expenditures exceed revenues in a given year, the difference is the budget deficit. The national debt is the accumulated sum of all past deficits minus surpluses, representing the total amount the government owes creditors. Persistent borrowing to finance deficits can raise interest rates through the crowding-out effect, in which increased government demand for loanable funds drives up the cost of borrowing and reduces private investment spending, partially offsetting the intended stimulus.
Automatic stabilizers are fiscal mechanisms that adjust with the economic cycle without requiring new legislation. Progressive income taxes automatically collect more revenue as incomes rise and less during downturns, while unemployment insurance and other transfer programs automatically expand when joblessness increases, supporting household incomes and aggregate demand in bad times. The fiscal multiplier captures the idea that an initial change in government spending or taxation produces a larger change in GDP; for example, if the multiplier is greater than 1, every dollar of new government spending generates more than a dollar of additional output.
The size of the multiplier depends on the marginal propensity to consume (MPC), the fraction of each additional dollar of income that households spend rather than save. When MPC is high, money circulates more vigorously through the economy, amplifying the impact of fiscal actions. Several theoretical concepts add nuance to fiscal analysis. The Laffer Curve suggests that tax revenue and tax rates have a non-linear relationship: above a certain point, raising rates discourages work and investment so much that revenue falls. Ricardian equivalence argues that consumers anticipate future taxes needed to repay government debt, so deficit-financed spending has the same effect as taxation today, neutralizing stimulus. The paradox of thrift similarly warns that if everyone simultaneously increases saving, total income may fall and leave the economy worse off, a classic example of the fallacy of composition.