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DP IB Economics: HL Your notes

3.6 Demand Management: Fiscal Policy

Contents
An Overview of Fiscal Policy
The Keynesian Multiplier
An Evaluation of Fiscal Policy

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An Overview of Fiscal Policy

Your notes
An Introduction to Fiscal Policy
Fiscal Policy involves the use of government spending and taxation (revenue) to influence aggregate
demand in the economy

Fiscal policy can be expansionary in order to generate further economic growth

Expansionary policies include reducing taxes or increasing government spending

Fiscal policy can be contractionary in order to slow down economic growth or reduce inflation
Contractionary policies include increasing taxes or decreasing government spending

Fiscal Policy is usually presented annually by the Government through the Government Budget
A balanced budget means that government revenue = government expenditure
A budget deficit means that government revenue < government expenditure
A budget surplus means that government revenue > government expenditure

A budget deficit has to be financed through public sector borrowing

This borrowing gets added to the public debt

Sources of Government Revenue

The main sources of government revenue include taxation, the sale of goods/services by government
owned firms, and the sale of government owned assets (privatisation)

1. Taxation
Direct taxes are taxes imposed on income and profits
They are paid directly to the government by the individual or firm
E.g. Income tax, corporation tax, capital gains tax, national insurance contributions,
inheritance tax
Indirect taxes are imposed on spending

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The supplier is responsible for sending the payment to the government

Depending on the PED and PES producers are able to pass on a proportion of the indirect tax Your notes
to the consumer
The less a consumer spends the less indirect tax they pay
E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on demerit goods, excise duties
on fuel etc.

2. Sale of goods/services
Government owned firms sometimes charge for the goods/services that they provide
E.g. Charges on public transport and fees paid to access some medical services

3. The sale of government owned assets

Privatisation can generate significant government revenue during the year in which the government
sells the asset
Most assets can only be sold once e.g. national airlines or railways
Some assets, such as the right for mobile phone operators to use the airwaves, can be sold every
few years (the airway license is for a defined period of time)

Government Expenditure
Government expenditure represents a significant portion of the aggregate demand in many
economies. The expenditure can be broken down into three categories
1. Current expenditures: These include the daily payments required to run the government and public
sector. E.g. The wages and salaries of public employees such as teachers, police, members of
parliament, military personnel, judges, dentists etc. It also includes payments for goods/services such
as medicines for government hospitals
2. Capital expenditures: These are investments in infrastructure and capital equipment. E.g. High speed
rail projects; new hospitals and schools; new aircraft carriers
3. Transfer payments: These are payments made by the government for which no goods/services are
exchanged. E.g. Unemployment benefits, disability payments, subsidies to producers and consumers
etc. This type of government spending does not contribute to aggregate demand as income is only
transferred from one group of people to another

The Goals of Fiscal Policy

Fiscal policy is used to help the government achieve their macroeconomic objectives

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Specifically, the use of fiscal policy aims to

Maintain a low and stable rate of inflation Your notes
Maintain low unemployment
Reduce the business cycle fluctuations
Create a stable economic environment for long-term economic growth
Redistribute income so as to ensure more equity
Control the level of exports and imports (net external balance)

When a policy decision is made, it creates a ripple effect through the economy impacting the
macroeconomic objectives of the government
Changes to fiscal policy can influence several of the components of AD
A change to any component of AD helps to achieve at least one of the goals of fiscal policy

Expansionary & Contractionary Fiscal Policy

1. Expansionary Fiscal Policy
Expansionary fiscal policies include reducing taxes or increasing government spending with the aim of
increasing AD

AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) -
imports (M)
AD = C + I + G + (X - M)

Expansionary fiscal policy aims to shift aggregate demand (AD) to the right

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Your notes

Classical diagram illustrating expansionary fiscal policy which increase real GDP (Y1 →Y2) and average
price levels (AP1 →AP2)

Diagram Analysis
The economy is initially in macroeconomic equilibrium AP1Y1 - there is a recessionary gap
The Government is wanting to boost economic growth and lowers the rate of income and corporation
taxes
Lower taxes cause investment and consumption to increase which are components of AD
Aggregate demand increases from AD→ AD1
The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a greater level of
national output
Examples of the Impact of Expansionary Fiscal Policy

Example 1: The Government decreases corporation tax

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Effect on the economy Firms net profits increase → investment by firms increases → AD increases
Your notes
Impact on Economic growth increases
macroeconomic aims
Inflation rises
Unemployment may decrease as output is rising which requires more
workers
Net external demand - unsure - exports may rise due to new investments
in the economy, but imports may rise due to higher income generated by
the investment

Example 2: The Government increases unemployment benefits

Effect on the Household income increases → consumption increases → AD increases

economy

Impact on Economic growth increases

macroeconomic aims
Inflation rises
Unemployment may decrease as output is rising which requires more
workers (although increased unemployment benefits may discourage
some people from entering the labour market)
Net external demand is unlikely to change as this policy helps the poorest
and imports are unlikely to increase
Redistribution of income has increased and there is more equity in society

2. Contractionary Fiscal Policy

Contractionary fiscal policies include increasing taxes or decreasing government spending with the
aim of decreasing AD

AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) -
imports (M)

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AD = C + I + G + (X - M)

Changes to fiscal policy can influence government spending or consumption or investment Your notes
Changing taxation can influence household consumption and the investment by firms

Contractionary fiscal policies aims to shift aggregate demand (AD) to the left

Keynesian diagram illustrating how a contractionary fiscal policy aims to decrease real GDP (YFE →Y1)
and average price levels (AP1 →AP2)

Diagram Analysis
The economy is initially in macroeconomic equilibrium AP1YFE - an inflationary output gap is
developing
The economy is booming and the Government is wanting to lower inflation towards its target of 2%
The Government increases the rate of income tax
Higher tax rates cause households to have less discretionary income causing consumption to
decrease
Aggregate demand decreases from AD1→ AD2

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The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller level of
national output
Your notes
Examples of the Impact of Contractionary Fiscal Policy

Example 1: The Government increases the rate of income tax

Effect on the economy Households pay more tax → discretionary income reduces →
consumption reduces → AD reduces

Impact on macroeconomic Economic growth slows down

aims
Inflation eases
Unemployment may increase as output is falling and fewer workers
are required
Net external demand Improves (with less income, imports may fall)

Example 2: The Government freezes/reduces public sector workers pay

Effect on the economy Wages stagnate or reduce → Consumer confidence falls → consumption
decreases → AD decreases

Impact on Economic growth slows down

macroeconomic aims
Inflation eases
Unemployment may increase as output is falling
Net external demand improves (with less income, imports may fall)

Example 3: The Government cuts Government Spending in their Budget

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Effect on the economy Less demand for goods/services → less income for firms → output and
profits decrease → AD decreases
Your notes
Impact on Economic growth slows down
macroeconomic aims
Inflation eases
Unemployment may increase as output is falling
Net external demand may Improve (with less income, imports may
fall)
Less corporation tax available for redistribution

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The Keynesian Multiplier

Your notes
An Introduction to the Keynesian Multiplier
The multiplier is the ratio of change in real income to the injection that created the change
E.g. If the Brazilian government injected an additional 5bn Brazilian real (BZL) into the economy
through government spending and it resulted in an increase in real income of 15bn BZL, the value of
the multiplier would be 3

The multiplier process is based on the idea that one individual's spending is another individual's
income
An increase in consumption immediately increases AD
Store owners who have benefitted from the extra consumption now have extra income
They spend some of that income on goods/services
Their expenditure on goods/services is now income for the next tier of individuals
Due to the successive rounds of spending, the final increase in national income is much larger
than the initial injection
The size of the multiplier is entirely dependent on the size of leakages that occur during the
process
The higher the leakages the smaller the multiplier
The initial injection shifts AD to the right
The result of the multiplier process is that there is then a secondary movement of AD to the right
which (if the multiplier were 2) may be double the initial movement
The multiplier can also work in reverse when injections are reduced (downward multiplier effect)

The Effects of Marginal Propensities on the Multiplier

The 'marginal propensities' refer to the proportion of the next $ earned that a consumer saves,
consumes, is taxed, or purchases imports with
Marginal propensities are calculated for economies and provide insights into how each additional $ of
income is allocated
Sweden has a higher tendency to save than the USA
Their marginal propensity to save is higher

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The USA, therefore, has a greater multiplier on any injections into the Circular Flow
An Explanation of the Marginal Propensities
Your notes

Marginal Propensity Explanation Formula

Marginal Propensity to The proportion of additional income that is spent ∆C

Consume (MPC) on consumption (C) MPC =
∆Y

Marginal Propensity to Save The proportion of additional income that is saved ∆S

(MPS) (S) MPS =
∆Y

Marginal Propensity to Tax The proportion of additional income that is paid ∆T

(MPT) in tax (T) MPT =
∆Y

Marginal Propensity to The proportion of additional income that is spent ∆M

Import (MPM) on imports (M MPM =
∆Y

Calculating the Multiplier

The value of the multiplier can be calculated one of two ways
By focusing on the marginal propensity to consume (MPC)
Or, by focusing on the withdrawals that occur on each additional $ of income (MPS + MPT + MPM)
1. Focussing on the MPC
1
Multiplier =
(1 −MPC)

2. Focusing on the Withdrawals

1 1
Multiplier = =
MPW (MPM + MPS + MPT)

Worked Example
An economy has the marginal propensity to save of 0.15, marginal propensity to tax of 0.20 and a
marginal propensity to import of 0.15.

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a) Calculate the size of the multiplier.

b) If the Government increases their infrastructure spending by £60m, calculate the total increase in Your notes
GDP, assuming all other things remain equal.
Answer:
Step 1: Insert the values into the withdrawal formula
1
Multiplier =
(MPM + MPS + MPT)

1 1
= =
(0. 15 + 0. 15 + 0. 20) 0.5

= 2

Step 2: Multiply the injection by the multiplier

Impact on GDP = Injection x multiplier
= £60m x 2
= £120m

Worked Example
Calculate the amount of government spending required to restore an economy's macroeconomic
equilibrium if the economy faces a $22bn recessionary gap and its MPC is 0.6 [2]
Answer:
Step 1: Calculate the multiplier
1
Multiplier =
(1 −MPC)

1 [1 mark]
Multiplier =
(1 −0.6)

Multiplier = 2.5

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Step 2: Calculate the value of government spending required

$ 22 bn Your notes
Government spending required =
2. 5
[1 mark]
Government spending required = $ 8. 80 bn

Significance of the Multiplier in Shifting Aggregate

Demand (AD)
The greater the withdrawals, the smaller the value of the multiplier - and vice versa
The greater the MPC, the higher the value of the multiplier - and vice versa
Any change in one of the factors that impacts on disposable income, will change the multiplier
If taxes increase the value of the multiplier reduces
If interest rates increase, savings increase and consumption decreases and the multiplier
reduces
If exchange rates appreciate the level of imports will increase and the multiplier decreases
If confidence in the economy increases consumption increases and the multiplier increases

It is extremely useful for the Government to know the value of the multiplier
They can use it to judge the likely economic growth caused by increased spending

There is a time lag as it takes time for the successive rounds of income to work through the economy

Examiner Tips and Tricks

The final bullet point above mentions time lags. This is an excellent point to include in any evaluation
on the effectiveness of the multiplier. It may take up to 18 months for the full multiplier effect to be
seen & any change to consumer confidence during this period will impact the final outcome.

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An Evaluation of Fiscal Policy

Your notes
Strengths of Fiscal Policy
Spending can be targeted at specific industries
It can be highly effective in restoring confidence in an economy during a deep recession
Redistributes income through taxation
Reduces negative externalities through taxation
Increased consumption of merit/public goods
Short term government spending can lead to an increase in the aggregate supply of an economy
E.g. Building a new airport immediately increases government spending and AD, but when it is
built, the potential output will have increased (Production Possibility Curve has shifted outward)

Automatic Stabilisers as a Strength of Fiscal Policy

Automatic stabilisers are automatic fiscal changes that occur as the economy moves through stages
of the business/trade cycle

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The impact of automatic stabilisers on an economy during a boom and recession

1. Effect in a recession Your notes
In a recession, there will (automatically) be lower tax revenue due to the nature of progressive
taxation - as incomes fall households are taxed less
In a recession, as unemployment rises, the government will pay higher unemployment benefits /
transfer payments which households will then be used for consumption
Both of the above will result in real GDP being higher than it would otherwise have been
2. Effect in a boom
In a boom, there will (automatically) be higher tax revenue due to the nature of progressive taxation -
as incomes rise households are taxed more
In a boom, as unemployment falls the government will pay less unemployment benefits / transfer
payments which households which then does not get generate increased consumption
Both of the above will result in real GDP being lower than it would otherwise have been
This is effectively an automatic disinflationary effect

Weaknesses of Fiscal policy

Political pressures: Policies can fluctuate significantly when new governments are elected
Long term infrastructure projects may lack follow-through

Unsustainable debt: Increased government spending can create budget deficits which are added to
the national debt
Repaying this debt may lead to austerity on future generations

Conflicts between objectives

E.g. Cutting taxes to increase economic growth may cause inflation

Time lags: It is difficult to predict exactly when the desired effect on the economy will occur. Fiscal
policy also takes a longer time to plan and implement than monetary policy
Government budgets are usually presented once a year whereas monetary policy adjustments
can take place 4-8 times per year

Crowding Out as a Weakness of Fiscal Policy

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Crowding out refers to a phenomenon where expansionary fiscal policy, particularly government
spending, can result in a reduction of private sector spending or investment
Your notes
Government borrowing results in competition with others in the economy who want to borrow the
limited amount of savings available
This competition causes the real interest rate to rise and private investment decreases (is
crowded out)

The diagram on the left shows how government borrowing increases interest rates, resulting in a fall in
AD in the diagram on the right as private firms are crowded out of the market

Diagram Analysis
Increased government borrowing causes the demand for money in the loanable funds market to
increase from DM1 →DM2
This extra demand raises interest rates from R1→R2
The government increases their spending using the borrowed funds and aggregate demand in the
economy increases from AD1→AD2
The increase in AD is greater than the actual value of the injection due to the Keynesian multiplier

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Private firms are put off from borrowing loanable funds due to the increased rate of interest and
investment falls
Your notes
As investment falls, aggregate demand decreases, shifting back to AD3

Private firms have been crowded out of the market by the governments actions

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