Demand Management — Fiscal Policy
Government revenue and expenditure, the Keynesian multiplier, automatic stabilisers, and evaluation of fiscal policy.
- Define fiscal policy; distinguish sources of revenue and types of expenditure
- Explain expansionary and contractionary fiscal policy using AD/AS diagrams
- Explain the Keynesian multiplier and perform calculations HL
- Explain automatic stabilisers and the crowding-out effect HL
- Evaluate the effectiveness of fiscal policy
This section is pending teacher review.
What is Fiscal Policy?
Fiscal policy is government use of taxation and public expenditure to influence the level of economic activity.
Government revenue
- Direct taxation (income tax, corporate tax, wealth taxes)
- Indirect taxation (VAT, excise duties)
- Sale of goods and services from state enterprises
- Sale of government assets (privatisation)
Government expenditure
- Current expenditure — day-to-day spending (wages, supplies)
- Capital expenditure — investment in infrastructure and assets
- Transfer payments — pensions, unemployment benefits, welfare payments (no direct output produced)
Goals of fiscal policy
- Low and stable inflation
- Low unemployment
- Stable environment for long-term growth
- Reduce business cycle fluctuations
- Equitable distribution of income
- External balance
Expansionary and Contractionary Fiscal Policy
| Expansionary | Contractionary | |
|---|---|---|
| Action | Increase G or cut taxes → budget deficit | Cut G or raise taxes → budget surplus |
| Effect | AD shifts right → higher output and price level | AD shifts left → lower output and price level |
| Used to close | Recessionary gap | Inflationary gap |
| Keynesian view | Effective especially in deep recession (flat Keynesian AS) | Effective but reduces growth momentum |
| New classical view | Crowds out private investment; economy self-corrects anyway | Less needed if markets self-correct |
Keynesian Multiplier HL
The Keynesian multiplier describes how an initial injection (e.g., government spending) leads to a larger final increase in national income. Each round of spending becomes another person's income, which is then partly re-spent.
Where MPC = marginal propensity to consume, MPS = marginal propensity to save, MPT = marginal propensity to tax, MPM = marginal propensity to import.
The change in national income = multiplier × initial injection
The multiplier is larger when MPC is high and leakages (MPS + MPT + MPM) are small.
Automatic stabilisers are features of the fiscal system that automatically offset economic fluctuations without requiring deliberate policy decisions:
- Progressive income taxes: In a boom, incomes rise → tax revenues rise automatically → reduces disposable income growth → dampens inflation. In recession, incomes fall → tax revenues fall → less drag on spending.
- Unemployment benefits: In a recession, more people claim benefits → government spending rises automatically → supports aggregate demand.
When the government increases spending and borrows to finance it, it competes for funds in financial markets, raising interest rates. Higher interest rates reduce private sector investment (I) and consumption (C). The increase in G is partially offset by a fall in private spending — this is crowding out.
Implication: fiscal policy is less effective than the multiplier alone suggests, especially when the economy is near full employment and interest rates rise significantly in response to government borrowing.
Effectiveness of Fiscal Policy
Strengths
- Can target specific sectors (e.g., infrastructure, low-income groups)
- Government spending is effective in a deep recession when private spending is very low
- Multiplier effect amplifies the initial stimulus
Constraints
- Political pressure — governments may resist spending cuts or tax rises for electoral reasons
- Time lags — policy must be debated, passed, and implemented (recognition, decision, and effect lags)
- Sustainable debt — large deficits accumulate government debt; raises debt servicing costs and may crowd out future spending
- Crowding out (HL) — higher borrowing may raise interest rates and reduce private investment
- Expansionary: G↑ or T↓ → AD↑; contractionary: G↓ or T↑ → AD↓
- Multiplier = 1 ÷ (MPS + MPT + MPM) (HL)
- ΔGDP = multiplier × initial injection (HL)
- Automatic stabilisers: progressive taxes + unemployment benefits (HL)
- Crowding out: government borrowing → higher rates → lower private investment (HL)
- Fiscal constraints: political pressure, time lags, debt levels
Worked examples are pending teacher review.
Worked Example — Keynesian Multiplier HL
MPS = 0.1, MPT = 0.2, MPM = 0.2. The government increases spending by $500 million.
Step 1: Calculate the multiplier
Step 2: Calculate the change in national income
An initial injection of $500m results in a $1bn increase in national income.
Practice questions are pending teacher review.
Show answer
(a) k = 1 ÷ (0.15 + 0.15 + 0.1) = 1 ÷ 0.4 = 2.5
(b) ΔGDP = 2.5 × $200m = $500 million