Fiscal policy refers to the government’s use of changes in taxation and public spending to influence aggregate demand (AD) and overall economic activity.

It helps stabilise the business cycle, achieve low and stable inflation (such as a 2% target), and promote full employment by shifting the AD curve rightward (to boost activity) or leftward (to moderate it) in AD-AS diagrams.

Automatic stabilisers like progressive taxation—which rises with income—and unemployment benefits provide counter-cyclical effects without needing new policy decisions.

Governments adjust tax rates to impact disposable income and spending power: lower taxes increase consumers’ and firms’ ability to spend, raising AD, while higher taxes do the opposite. Public spending on infrastructure, welfare, or services directly injects or withdraws funds from the economy.

Types of fiscal policy:

• Expansionary fiscal policy: Involves cutting taxes or increasing spending to stimulate demand during recessions, supporting growth and reducing unemployment, though it risks widening budget deficits.
• Contractionary fiscal policy: Involves raising taxes or cutting spending to dampen demand in overheating economies, curbing inflation but potentially slowing growth and raising unemployment.