What it is:
Fiscal policy refers to a government's spending and taxation policies intended to maintain economic stability, which is indicated by levels of unemployment, interest rates, prices and economic growth.
How it works (Example):
A government is capable of directly affecting economic activity in response to fluctuations in macroeconomic growth. Via taxation and public spending, a government can control price inflation, unemployment rates, and interest rate levels.
For instance, in order to curb price inflation, which is associated with high levels of consumer spending, a government may institute higher taxes resulting in lower levels of disposable income. Likewise, a government might engage in public spending in order to increase an economy's cash flow during times of recession.
Why it Matters:
As the administrative body responsible for public wellbeing, a government implements fiscal policy in an effort to defend the interests of businesses and consumers from economic forces which, if left unchecked, could have adverse consequences.