Fiscal policy is the use of government expenditure and taxation to manage the economy. The main changes in fiscal policy happen once a year in the Budget. It is in the Budget that the Chancellor sets the levels of taxation and government expenditure for the next fiscal year. The fiscal year runs from 6th April one year until 5th April the following year. This is why the budget is usually in March. The changes in it come generally into effect in the following month. In the Virtual Economy life is a lot easier - you can make changes any time you like! Just use the link to the model in the top navigation bar or on the 4th floor in the side bar to get there from anywhere in the Virtual Economy.

Fiscal policy can be used in various different ways. It may be used to try to boost the level of economic activity when the economy is flagging a little. In this case it is called expansionary policy. Alternatively the economy may be doing a little too well and in need of slowing down. In this case contractionary policy is called for. The final use for fiscal policy is as a tool of supply-side policy.

To help imagine how these policies work think of the economy as a balloon. The air in the balloon is the level of demand or economic activity. If the balloon is a little low and short of air you want to expand it, but if it is over-expanded and in danger of bursting then you contract it. The same is true of the economy, though when it is over-expanded instead of bursting we get other problems such as higher inflation and a larger balance of payments deficit. Supply-side policies are then policies that manage the capacity of the balloon; making it bigger so it can take more air or making the balloon material more stretchy so it can expand further and so on.

Governments may choose to use expansionary fiscal policy in times of recession or a general downturn in economic activity. In this situation they will use their fiscal policy to give a boost to the economy. They may do this by lowering taxes in some form or by increasing the level of government expenditure. This will encourage people to spend more. If the government lowers taxes it will raise people's disposable income (their take-home pay) and therefore encourage them to spend more. Lower taxes will also lower the prices of taxed goods and encourage more quantity demanded. Alternatively,  Either way the level of demand in the economy should rise and help encourage economic growth.

Expansionary fiscal policies could therefore include:

• Cutting tax rates
• Increasing the level of personal allowances and deductions
• Increasing the level of government expenditure

Why not try some of these policies on your Virtual Economy? Try any of these policies and see the effect they have on the level of economic growth, unemployment and inflation. You should find growth increasing, unemployment falling and inflation rising (after a time-lag perhaps).

Contractionary fiscal policy is likely to be most appropriate in times of economic boom. If the economy is growing at above its capacity this is likely to cause inflation and balance of payments problems. To try to slow the economy down the government could either raise taxes in some form or perhaps reduce government expenditure. Either of these will reduce the level of demand in the economy and therefore the level of economic growth. It may increase taxes which will raise prices and deter people from spending so much, and which will also leave people with less money in their pockets and so stop them from spending so much.

Contractionary fiscal policies could therefore include:

• Increasing tax rates
• Reducing the level of personal allowances and deductions
• Reducing the level of government expenditure

Why not try some of these policies on your Virtual Economy? Try any of these policies and see the effect they have on the level of economic growth, unemployment and inflation. You should find growth reducing, unemployment increasing and inflation falling (after a time-lag perhaps).

Supply-side policies are policies that aim to use Keynesian theory to increase the capacity of the economy to produce. Fiscal policy usually acts on the level of demand in the economy and the contractionary and expansionary policies described above are often known as demand-side policies. However, it is also possible for fiscal policy to act on the level of supply as well.

Income tax will always have an effect on people's incentives to work. This will be true at most income levels. If income tax at low income levels is too high, people may choose not to work but to remain on benefits instead. If income tax on high levels of income is too high, people may choose not to work so hard and take risks. Ultimately they may even choose to leave the country if taxes elsewhere are much lower (a "brain drain").

Supply-side fiscal policies could therefore include:

• Cutting the lower and basic rates of tax to open up the gap between earnings in and out of work and ensure people have an incentive to work
• Increasing the level of personal allowances for the same reason
• Reducing the top rate of tax to encourage enterprise, risk-taking and the incentive to work hard

Why not try some of these policies on the Virtual Economy? Try this and see the effect they have on economic growth and unemployment. When you cut taxes ensure you cut government expenditure by an equivalent amount. This ensures that your policies have no overall impact on demand. In this way you isolate out the supply-side impact of your policies. You should see an overall increase in economic growth over time as your policies begin to take effect.

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