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AP® Macroeconomics · Unit 3 · Topic 3.8

Fiscal Policy: Revision Notes (Macroeconomics 3.8)

One-page recap of fiscal policy tools, expansionary and contractionary policy, the gap-closing calculation with spending and tax multipliers, and the lags in discretionary policy.

Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.

Recap

  • Fiscal policy: the government’s changes to spending and taxes/transfers to reach goals such as full employment and stable prices.
  • Government spending is a component of AD, so it changes AD directly.
  • Taxes and transfers change disposable income, then consumption (or investment), so they change AD indirectly.
  • Expansionary policy (G ↑, taxes ↓, transfers ↑) closes a recessionary gap. Contractionary policy (G ↓, taxes ↑, transfers ↓) closes an inflationary gap.
  • In the short run, fiscal policy changes AD, real output and the price level (and unemployment in the opposite direction to output).
  • Lags: it takes time to recognise a gap, decide on a policy, implement it, and for it to take effect.

Key relationships

Quantity Formula
Spending multiplier 1 ÷ MPS = 1 ÷ (1 − MPC)
Tax multiplier −MPC ÷ MPS
Change in G needed output gap ÷ spending multiplier
Change in taxes or transfers needed output gap ÷ size of tax multiplier
MPC Spending multiplier Tax multiplier G needed for a 20 gap Tax change needed for a 20 gap
0.75 4 −3 5 6.67
0.8 5 −4 4 5
0.9 10 −9 2 2.22

Assumptions

  • The price level is treated as constant in the calculations, so the AD shift equals the change in real GDP. With an upward-sloping SRAS, real GDP actually rises by a little less.
  • The MPC is constant and saving is the only leakage.
  • Monetary policy (central bank, interest rates) is a separate tool, studied in Unit 4.

Mistakes to avoid

  1. Multiplying the gap by the multiplier instead of dividing.
  2. Using the spending multiplier for taxes or transfers.
  3. Counting transfers as G.
  4. Wrong direction: a recessionary gap needs expansionary policy.
  5. Saying expansionary policy lowers the price level. It raises it in the short run.
  6. Forgetting lags when asked why fiscal policy may not stabilise the economy.

Quick self-check

  1. MPC 0.8, recessionary gap of VD 20 billion. Minimum rise in G? (VD 4 billion)
  2. Same economy. Tax cut needed instead? (VD 5 billion)
  3. Real GDP is above Yf. Name one fiscal action. (Cut G, raise taxes or cut transfers.)

Next: practice questions.

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