When a recession hits, governments rarely sit on their hands. They cut taxes, hand out checks, and launch building projects. This deliberate use of government spending and taxation to influence the whole economy is fiscal policy — one of the two great levers for steering total demand.
It pulls in two directions. Expansionary fiscal policy boosts the economy when it is weak. The government spends more or taxes less, putting money in people's pockets so they spend, which lifts aggregate demand. Contractionary fiscal policy does the reverse when the economy overheats. The government spends less or taxes more to cool things down and tame inflation.
Some of this happens without any new law. Automatic stabilizers are features already baked into the budget that respond on their own. In a downturn, tax revenue falls because incomes drop, and welfare payments rise because more people qualify. Both cushion the fall in spending instantly, with no politician needing to act.
The reason a small nudge can have a big effect is the spending multiplier. One dollar of government spending becomes income for someone, who spends part of it, becoming income for someone else, and so on. The total boost to GDP ends up larger than the original dollar. The size of the effect hinges on one number.
That number is the marginal propensity to consume (MPC) — the fraction of each extra dollar of income that people spend rather than save. If people spend 80 cents of every extra dollar, the MPC is 0.8. The multiplier is then $1/(1 - MPC)$, which works out to 5. A 100 dollar injection ripples out to 500 dollars of extra GDP.
Taxes have their own multiplier, and it is weaker. A tax multiplier is smaller than the spending multiplier, because when the government hands you a tax cut, you save part of it. Only the portion you spend enters the multiplier chain, so the same dollar of tax cut moves GDP less than a dollar of direct spending.
Fiscal policy is not a free lunch. Crowding out is the risk that heavy government borrowing pushes up interest rates, which discourages private investment and offsets part of the boost. And persistent gaps between spending and revenue pile up. Deficits are the yearly shortfalls, while debt is the accumulated total. Run deficits long enough and interest payments crowd out everything else, which is the limit on how far fiscal policy can go.