Fiscal policy is a economic term that defines the set of principles and decisions of a government in setting the level of public expenditure and how that expenditure is funded.
Fiscal policy and monetary policy are the macroeconomic tools that governments have at their disposal to manage the economy. Fiscal policy is the deliberate thought and process to bring change in government spending, government borrowing or taxes to stimulate or slow down the economy. It contrasts with monetary policy, where the latter describes policies concerning the supply of money to the economy.
Fiscal policy is described as being either neutral, expansionary, or contractionary.
An expansionary fiscal policy occurs when the government lowers taxes and/or increases spending; thus expanding output (national income).
An increase in government spending or a cut in taxes shifts the aggregate demand curve to the right. An expansionary fiscal policy will expand the growth of the economy.
A contractionary fiscal policy occurs when the government raises taxes and/or lowers spending; thus lowering output (national income).
A decrease in government purchases or an increase in taxes shifts the aggregate demand curve to the left. A contractionary fiscal policy will constrict the economy’s overall growth.