Fiscal policy is where the overall economic activity is manipulated through government intervention such as government spending and taxation. Unlike monetary policy which is implemented by the Central Bank, fiscal policy is implemented by the government.
Solving Economic Problems using Fiscal Policy
When there are inflationary pressures in the economy, the government reduces its spending in order to curb inflation. The government also increases taxation to take money away from the public to achieve the same objective. This is what is referred to as contractionary fiscal policy. On the other hand, when there is slowness in the economy and the financial system, the government attempts to increase economic activity by increasing its spending and reducing taxation. This is what is known as expansionary fiscal policy. Therefore, the two instruments of fiscal policy are government spending and taxation and these are changed by the government in order to manipulate the money supply in the economy to solve for both inflationary and deflationary situations.
An increase in government spending or an expansionary fiscal policy is achieved by running a budget deficit because the spending usually exceeds the revenues of the government. On the other hand, a reduction in government spending or a contractionary fiscal policy is achieved by running a budget surplus because revenues usually exceed spending. A neutral stance of fiscal policy implies a balanced budget where G = T (Government spending = Tax revenue). Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity.