Final answer:
Governments use fiscal policy to influence the economy through expansionary and contractionary measures. Expansionary policy, like reducing tax rates, increases consumer spending and can lead to a budget deficit. Conversely, contractionary policy, like increasing taxes, can reduce consumer spending and slow economic growth.
Step-by-step explanation:
Fiscal policy is a critical tool used by governments to manage the economy. By employing either expansionary or contractionary fiscal policies, the government can influence economic growth, employment, and inflation.
An expansionary fiscal policy is used to stimulate the economy by increasing aggregate demand through government spending or decreasing taxation. For example, when the government decides to reduce tax rates, consumers have more disposable income, leading to increased consumer spending and the ability to save more. This, in turn, can result in a budget deficit if government expenditures exceed tax revenues.
In contrast, a contractionary fiscal policy aims to slow down economic growth and curb inflation by reducing aggregate demand. This could occur when the government decides to increase taxation, leading to decreased consumer spending and potentially less development in public services such as roads and hospitals due to lower government spending.