Demand-side policy: fiscal policy

Fiscal and monetary policy

• Fiscal policy: changes in government spending and taxation, decided by the government (finance ministry).
• Monetary policy: changes in interest rates, the money supply and credit, usually set by the central bank.
• Reflationary (expansionary) policy raises AD: more spending, lower taxes, lower interest rates.
• Deflationary (contractionary) policy reduces AD: less spending, higher taxes, higher interest rates.

Fiscal instruments

• Government spending on goods and services (G) directly changes AD; an increase has a multiplier effect.
• Taxation: direct taxes on income and profits (income tax, corporation tax) change disposable income and profits; indirect taxes (VAT, excise duties) change prices and spending.

The budget balance = tax revenue - government spending. A deficit means borrowing; a surplus means repaying debt.

Strengths

• Can be targeted at particular groups, regions or industries (for example spending on infrastructure in a poor region).
• Government spending acts directly on AD and has a multiplier effect, which is useful in deep recessions when interest rates are already near zero.
• Automatic stabilisers (tax revenue falls and benefit spending rises in a downturn) work without new decisions.

Weaknesses

• Time lags: recognising the problem, passing the budget and carrying out projects takes time.
• Expansion raises the budget deficit and national debt, and future interest payments.
• Crowding out: government borrowing may raise interest rates and reduce private investment.
• The size of the multiplier is uncertain, and in an open economy much extra spending leaks into imports.
• Political pressures may lead to giveaways before elections; tax rises are unpopular.
• Near full capacity, expansionary fiscal policy causes inflation rather than growth.

Worked example

A government cuts income tax so households have $20 bn more disposable income. The MPC is 0.8 and the multiplier is 1 / (1 - MPC). Estimate the final change in national income.

1. Households spend 0.8 x 20 = $16 bn in the first round (they save the rest).
2. Multiplier = 1 / (1 - 0.8) = 5
3. Final change = 5 x 16 = 80

Answer: National income rises by about $80 bn: a tax cut has a smaller effect than the same rise in G, because part is saved at once.

Check yourself

1. Which is a reflationary fiscal policy?
   • Raising the rate of VAT
   • Raising interest rates
   • Increasing government spending on infrastructure
   • Selling government bonds to reduce the money supply
   Show answer

   Increasing government spending on infrastructure. Higher G raises AD directly.

2. Which is a deflationary fiscal policy?
   • Raising income tax rates
   • Cutting interest rates
   • Quantitative easing
   • Increasing welfare payments
   Show answer

   Raising income tax rates. Higher income tax reduces disposable income and C.

3. The government raises spending by $15 bn and the multiplier is 1.6. Find the final change in national income in $ bn.
   Show answer

   $24 bn. 1.6 x 15 = $24 bn.

4. Government spending is $520 bn and tax revenue $495 bn. Find the budget deficit in $ bn.
   Show answer

   $25 bn. 520 - 495 = $25 bn deficit.

5. 'Crowding out' refers to
   • too many people using public services
   • imports replacing domestic goods
   • taxes falling in a recession
   • government borrowing raising interest rates and reducing private investment
   Show answer

   government borrowing raising interest rates and reducing private investment. Competition for funds pushes up borrowing costs for private firms.

6. Which is an automatic stabiliser?
   • A new road building programme
   • Spending on unemployment benefits rising during a recession
   • A cut in interest rates
   • A one-off tax cut announced in the budget
   Show answer

   Spending on unemployment benefits rising during a recession. It happens without any new policy decision.

7. A weakness of using new public infrastructure projects to fight a recession is that
   • they do not affect AD
   • they reduce the budget deficit
   • they always cause deflation
   • they may take years to plan and start, by which time the recession is over
   Show answer

   they may take years to plan and start, by which time the recession is over. Implementation lags are long.

8. Explain why a $10 bn tax cut may raise AD by less than a $10 bn rise in government spending.
   Show answer

   Part of the tax cut is saved (or spent on imports) rather than spent, so the first-round injection is smaller, whereas the whole of the government spending is an injection.. Only the MPC share of a tax cut is spent in the first round.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification, Issue 2 (June 2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.