How can fiscal policy affect the economy?

1 Answer
Nov 26, 2015

When the government raises taxes, it decreases yield. However, when government increases expenditure, it increases yield.


Fiscal policy is a tool the government uses to manage its revenues and expenditures. The revenue side is controlled mainly by taxes. When the government increases taxes to keep a cash surplus, it decreases the available yield. That occurs because people have to pay more taxes, so they have less money available to spend on consumption of goods. On the other hand, decreasing taxes would increase the public deficit, but increase yield and consumption.

On the expenditure side, the government may decide to spend the money it got from taxes. The expenditure can be increased either by buying goods from the private sector or by hiring more civil servants. Either way, the yield will increase when the government increases expenditure. However, once the deficit gets too high, the government will start to save money, reducing aggregate demand and, consequently, yield.

Always keep in mind the basic keynesian formulas:
Where Y is the yield, I is investment, G are the governmental expenditures, X are exports and M are imports. C is a function of an autonomous consumption #(c)# plus a marginal consumption #(M_C)# times the available yield #(Y_a)#. The available yield is total yield minus taxes #(T)#.