Fiscal policy

Fiscal policy is a policy connected with government spending and taxation decisions. By using fiscal policies, government influence aggregate demand. It can raise AD by reducing income taxes, for example, and increasing government spending. AD consists of different components, such as Investment, Government spending, consumption and trade balance. If government decided to reduce corporation tax and thereby increase firms’ profit, it can affect Investment, because more firms would be able to invest. If government reduces income tax, disposable income of people will increase and this will lead to an increase in AD because of another component. Government might increase it’s spending on capital goods or public, create more workplaces and so, unemployment rates will go down and this injection is likely to have multiplier effect, causing AD to rise. 

But not all the policies are created to increase an AD, which is known as reflationary policy, sometimes government might decide to reduce AD in order not to have high inflation rates and reduce consumption of demerit goods. This policy is known as deflationary. By increasing taxes or reducing government spending government might achieve this objective.

There are two rules in the UK which government introduced by itself and has to follow them. One of them is ‘golden rule’ which states that government might borrow only for investment purposes. And so this borrowing in the future will be cancelled out by government surpluses arising from investment. Another rule is ‘sustainable investment rule’ according to which government borrowing should never exceed 40% of GDP. These are self-imposed rules however government shouldn’t break them because following them will give international markets confidence about the UK’s market.