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What Is Fiscal Policy?

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Expansionary Fiscal Policy

Fiscal policy is referred to as "expansionary" when its goal is to stimulate the economy or, more specifically, increase aggregate demand in an economy in order to fight recessions. Since government expenditure is one component of aggregate demand, it's not surprising that increases in government spending are classified as expansionary fiscal policy.

Decreases in taxes are also classified as expansionary fiscal policy, since lowering taxes on households gives them more disposable income, which leads to more consumption and/or more saving. Since consumption is a component of aggregate demand, it follows that decreasing taxes increases aggregate demand, all else being equal.

In addition, an increase in saving by households serves to lower real interest rates, which in turn increases the quantity of investment in an economy. Since investment is a component of aggregate demand, it again follows that decreasing taxes increases aggregate demand.

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