Syllabus points
- Define fiscal policy and identify the sources of government revenue and expenditure.
- Explain how fiscal policy is used to influence aggregate demand.
- Distinguish expansionary from contractionary fiscal policy.
- Evaluate the strengths and limitations of fiscal policy.
What fiscal policy is
Fiscal policy is the use of government spending and taxation to influence aggregate demand and achieve macroeconomic objectives. It is set by the government (unlike monetary policy, which is set by an independent central bank).
| Side of the budget | Examples |
|---|---|
| Government revenue | Income tax, corporation tax, VAT/indirect taxes, national insurance |
| Government expenditure | Health, education, infrastructure, defence, transfer payments |
The budget balance is the difference between the two. A budget deficit (spending > revenue) adds to national debt; a budget surplus (revenue > spending) reduces it.
How fiscal policy shifts AD
Recall AD = C + I + G + (X − M). Fiscal policy acts on AD directly and indirectly:
- Government spending (G) is a component of AD, so a change in G shifts AD immediately.
- Taxation works indirectly: lower income tax raises disposable income and consumption (C); lower corporation tax raises retained profit and investment (I).
- The multiplier magnifies the initial change: an injection is re-spent in successive rounds, so the final change in national income exceeds the initial injection.
| Stance | Action | Aim |
|---|---|---|
| Expansionary | Raise G and/or cut taxes | Increase AD in a recession, reduce unemployment |
| Contractionary | Cut G and/or raise taxes | Reduce AD to control demand-pull inflation |
Automatic stabilisers
Some fiscal effects happen without a policy decision. In a downturn, tax revenue falls and unemployment benefit spending rises, automatically cushioning the fall in AD; in a boom the reverse applies. These automatic stabilisers reduce the size of the economic cycle before any discretionary action is taken.
Evaluation
- Strengths: targeted — spending can be directed at a specific region, industry or group; capital spending on infrastructure, education and health can raise both AD now and LRAS later; effective when monetary policy is weak (for example in a liquidity trap).
- Limitations: time lags (recognition, decision and implementation lags can be long, especially for capital projects); crowding out, where government borrowing raises interest rates and displaces private investment; the opportunity cost of the spending and the sustainability of rising debt; and political pressures that make tax rises and spending cuts difficult.
Worked example
A government facing a recession raises spending by $10bn. If the multiplier is 1.5, the eventual increase in national income is 10 × 1.5 = $15bn. With spare capacity, most of this is extra real output; near full capacity, more of it appears as inflation. The rise must be financed by borrowing, adding to debt.
Common exam mistakes
- Confusing fiscal policy (government, tax and spending) with monetary policy (central bank, interest rates).
- Assuming a budget deficit is always bad — in a recession it can be the appropriate response.
- Forgetting the multiplier when calculating the final effect on national income.
Exam technique
Trace the mechanism from the fiscal instrument through the AD component to output and the price level, then evaluate using lags, crowding out and debt sustainability.
Quick revision
- Fiscal policy = government spending + taxation, set by government.
- Expansionary (raise G / cut T) vs contractionary (cut G / raise T).
- Multiplier magnifies the initial injection; automatic stabilisers work without a decision.
- Limits: time lags, crowding out, opportunity cost, debt sustainability.