Series 3: 6.1.6.1.1. Fiscal Policy Defined

6.1.6.1.1. Fiscal Policy Defined

The size of a nation’s economy is measured by its gross domestic product. Gross domestic product (GDP) is the total dollar value of all goods and services produced within the nation’s borders over a specified period of time. It can be broken down by the following formula:

GDP = consumer spending + government spending + investment + (exports – imports)

As government spending represents about 20% of GDP, the federal government has significant power to manage the business cycle through its fiscal policy. Fiscal policy is the use of government revenue to manage economic production.

A government’s principal tools of fiscal policy are public spending and taxation. Obviously, an increase in government spending will increase the size of the economy. But changes in government spending and tax policy also impact the other elements of GDP: consumer spending, investment, and net exports. In addition, government borrowing in the form of deficit spending impact interest rates by increasing the demand for capital. An increase in demand for credit means higher interest rates. The president and Congress implement fiscal policy by increasing or decreasing taxes and government spending. The Treasury Department secures the financing by collecting the taxes and issuing new debt.

During a period of expansion, the government may use contractionary fiscal polic