Fiscal Policy Measures

Exam code: 2281

Written by: Ashika|Reviewed by: Caroline Carroll|Updated 2 July 2026

Understanding fiscal policy

Understanding fiscal policy

Fiscal policy involves the use of government spending and taxation (revenue) to influence total (aggregate) demand in the economy
Fiscal policy is usually presented annually by the government through the Government Budget
- Fiscal policy can be expansionary in order to generate further economic growth
- Fiscal policy can be contractionary in order to slow down economic growth or reduce inflation

Fiscal policy measures

Fiscal policy measures

When using fiscal policy, the government can change two main elements:

Changes in taxes

Reducing taxes increases consumers’ disposable income and may encourage higher spending
Increasing taxes reduces disposable income, lowering spending and potentially slowing inflation

Changes in government spending

Increasing spending boosts demand for goods and services, creating jobs and encouraging growth
Decreasing spending reduces total (aggregate) demand, which can slow inflation but may lead to higher unemployment

The effects of fiscal policy on macroeconomic aims

The effects of fiscal policy on macroeconomic aims

To understand the effects of fiscal policy on an economy, it is useful to know how total demand (gross domestic product) is calculated
Total (aggregate) demand = household consumption (C) + firms' investment (I) + government spending (G) + exports (X) - imports (M)

$AD = C + I + G + (X - M)$

From this, it is logical that changes to fiscal policy can influence any of these components – and often several of them at once

Expansionary fiscal policy

Lower taxes and/or higher government spending
- Increases total (aggregate) demand in the economy, encouraging higher output and employment
- Useful during a recession to boost economic growth and reduce unemployment
May risk higher inflation if total (aggregate) demand grows too quickly
Can be directed towards sustainable growth by funding renewable energy, public transport, and green infrastructure

Contractionary fiscal policy

Higher taxes and/or lower government spending
- Reduces demand in the economy, helping to control inflation
- Useful when the economy is overheating or inflation is high
May slow growth and increase unemployment if used for too long
Can support environmental sustainability by reducing subsidies for polluting industries and increasing taxes on harmful activities (e.g. carbon taxes)

Link to macroeconomic aims

Macroeconomic aim	How fiscal policy can help achieve it
Economic growth	Increase government spending on projects and cut taxes to encourage spending and investment
Lower inflation	Raise taxes or reduce spending to lower total demand and reduce price pressures
Lower unemployment	Fund job creation schemes and infrastructure projects, lower taxes to stimulate hiring
Healthy balance of payments	Tax imports (tariffs) to reduce demand for foreign goods and support domestic industries
Fairer income distribution	Use progressive taxes and targeted government spending to reduce inequality
Sustainability	Fund renewable energy, protect natural resources and use environmental taxes to encourage greener behaviour

Examples of fiscal policy

Examples of fiscal policy

Contractionary fiscal policy

Example 1	The government increases income tax levels
Effect on the economy	Consumers pay more tax → discretionary income reduces → consumption reduces → total demand reduces
Impact on macroeconomic aims	Economic growth slows down Inflation eases Unemployment may increase as output is falling and fewer workers are required Current Account Improves (with less income, imports may fall)

Example 2	The government freezes/reduces public sector workers pay
Effect on the economy	Wages stagnate or reduce → Consumer confidence falls → consumption decreases → total demand decreases
Impact on macroeconomic aims	Economic growth slows down Inflation eases Unemployment may increase as output is falling Current Account improves (with less income, imports may fall)

Example 3	The government cuts public spending in its budget
Effect on the economy	Less demand for goods/services → less income for firms → output and profits decrease → total demand decreases
Impact on macroeconomic aims	Economic growth slows down Inflation eases Unemployment may increase as output is falling Current Account improves (with less income, imports may fall) Less corporation tax available for redistribution Sustainability may worsen due to lower green subsidies being available

Expansionary fiscal policy

Example 1	The government decreases corporation tax
Effect on the economy	Firms' net profits increase → investment by firms increases → total demand increases
Impact on macroeconomic aims	Economic growth increases Inflation rises Unemployment may decrease as output is rising, which requires more workers Current Account – Unsure – Exports may rise due to new investments in the economy, but imports may rise due to higher income generated by the investment

Example 2

The government increases unemployment benefits

Effect on the economy

Household income increases → consumption increases → total demand increases

Impact on macroeconomic aims

Economic growth increases
Inflation rises
Unemployment may decrease as output is rising, which requires more workers (although increased unemployment benefits may discourage some people from entering the labour market)
The Current Account is unlikely to change, as this policy helps the poorest and imports are unlikely to increase
Redistribution of income has increased and there is more equity in society

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