Fiscal Policy: Study Guide (Macroeconomics 3.8)

What fiscal policy is

In Topic 3.7 you saw that, with no government action, an economy with an output gap eventually returns to full-employment output (Yf). The wait can be long, and in a recession it means high unemployment for years. Fiscal policy is one way a government can act instead.

Key definitions:

• Fiscal policy: changes in government spending and in taxes or transfer payments, made by the government to reach macroeconomic goals such as full employment, price stability and growth.
• Government spending (G): government purchases of goods and services, such as roads, school buildings and teachers’ salaries.
• Taxes: payments to the government, such as income tax and taxes on businesses.
• Transfer payments: payments from the government for which no good or service is provided in return, such as pensions or unemployment benefits. They are not part of G.
• Expansionary fiscal policy: raising government spending, cutting taxes or raising transfers. It shifts AD right.
• Contractionary fiscal policy: cutting government spending, raising taxes or cutting transfers. It shifts AD left.
• Discretionary fiscal policy: a deliberate decision to change spending or taxes. (Changes that happen automatically, without a new decision, are the topic of 3.9.)

Do not mix fiscal policy up with monetary policy, which is carried out by the central bank through the money supply and interest rates (Unit 4).

Direct and indirect effects on AD

Recall that AD = C + I + G + NX. The fiscal tools reach AD in two different ways.

• Government spending affects AD directly. G is one of the components of AD. When the government buys VD 1 billion more of goods, AD rises by VD 1 billion in the first round, before any multiplier effect.
• Taxes and transfers affect AD indirectly. They change households’ disposable income. Households then change consumption by only the MPC of that change and change saving by the rest. A tax cut on businesses can also raise investment. Either way, the effect works through C (or I), not through G.

This is why, as you saw in Topic 3.2:

Spending multiplier = 1 ÷ MPS and tax multiplier = −MPC ÷ MPS

The size of the government spending multiplier is always larger than the size of the tax multiplier. A rise in transfers works like a tax cut of the same size: it raises AD by MPC ÷ MPS for each valda.

Matching the policy to the gap

Situation	Unemployment	Policy needed	Tools	Short-run effects
Recessionary (negative) gap: real GDP < Yf	Above the natural rate	Expansionary	G ↑, taxes ↓, transfers ↑	AD right: real GDP ↑, price level ↑, unemployment ↓
Inflationary (positive) gap: real GDP > Yf	Below the natural rate	Contractionary	G ↓, taxes ↑, transfers ↓	AD left: real GDP ↓, price level ↓ (or rises less), unemployment ↑

The aim in both cases is to move real GDP to Yf, where unemployment equals the natural rate. Fiscal policy influences aggregate demand, real output and the price level together. (It can also affect exchange rates, which you will meet in Unit 6.)

Calculating the change needed to close a gap

The question is usually: what is the smallest change in G (or in taxes, or in transfers) that would close the gap? Work backwards from the size of the gap:

Change in G needed = output gap ÷ spending multiplier Change in taxes (or transfers) needed = output gap ÷ size of the tax multiplier

Then state the direction: increase G or cut taxes for a recessionary gap; cut G or raise taxes for an inflationary gap.

Assumption. These calculations treat the price level as constant, so the shift in AD equals the change in real GDP. This is the usual way such calculations are set. In the full AD–AS model, SRAS slopes upward, so part of any AD shift raises the price level and real GDP rises by a little less than the shift (look at Figure 1: AD shifts right by more than the distance from Y₁ to Yf).

Worked example 1: closing a recessionary gap in Valdoria

Valdoria is the fictional country used across the Marlbridge macroeconomics pages; its currency is the valda (VD). All data are fictional.

Question. Valdoria’s real GDP is VD 810 billion and its full-employment output is VD 840 billion. The MPC is 0.75. The natural rate of unemployment is 5.0%, and each VD 40 billion of output is 1 percentage point of unemployment.

(a) Identify the gap and the unemployment rate. Which type of fiscal policy is needed? (b) Calculate the minimum increase in government spending that would close the gap. (c) Calculate the tax cut that would close the gap instead. (d) Calculate the increase in transfer payments that would close the gap. (e) State the short-run effect of the policy on AD, real GDP, the price level and unemployment.

(a) Real GDP is below Yf by 840 − 810 = VD 30 billion: a recessionary gap. Unemployment is 5.0 + 30 ÷ 40 = 5.75%, above the natural rate. Expansionary fiscal policy is needed.

(b) MPS = 1 − 0.75 = 0.25. Spending multiplier = 1 ÷ 0.25 = 4. ΔG = 30 ÷ 4 = +VD 7.5 billion.

(c) Tax multiplier = −0.75 ÷ 0.25 = −3. Tax cut = 30 ÷ 3 = VD 10 billion. Step by step: a VD 10 billion tax cut raises disposable income by 10; households spend 0.75 × 10 = VD 7.5 billion in the first round; 7.5 × 4 = VD 30 billion. ✓

(d) Transfers work like a tax cut: an increase of VD 10 billion.

(e) AD shifts right. Real GDP rises towards VD 840 billion, the price level rises, and unemployment falls towards 5.0%.

Check. 7.5 × 4 = 30 ✓ and 10 × 3 = 30 ✓. The spending route needs less money (VD 7.5 billion against VD 10 billion) because all of the new spending enters AD in the first round, while part of a tax cut is saved. A common error is to multiply the gap by the multiplier (30 × 4 = 120): that gives a huge overshoot.

Worked example 2: cooling an inflationary gap in Kestria

Question. Kestria, a fictional neighbour of Valdoria (values in VD billion), has real GDP of 636 and full-employment output of 600. Its MPC is 0.75.

(a) Identify the gap and the type of fiscal policy needed. (b) Calculate the decrease in government spending that would close the gap. (c) Calculate the tax increase that would close the gap instead. (d) The government cuts spending by VD 3 billion and closes the rest of the gap with a tax increase. How large must the tax increase be?

(a) Real GDP is above Yf by 636 − 600 = VD 36 billion: an inflationary gap. Unemployment is below the natural rate and the price level is under upward pressure. Contractionary fiscal policy is needed.

(b) Spending multiplier = 4. ΔG = −36 ÷ 4 = −VD 9 billion (cut G by 9).

(c) Tax multiplier = −3. Tax increase = 36 ÷ 3 = VD 12 billion. A VD 12 billion tax rise cuts disposable income by 12, so consumption falls by 0.75 × 12 = VD 9 billion in the first round; 9 × 4 = 36. ✓

(d) The spending cut lowers AD by 3 × 4 = VD 12 billion. Remaining gap: 36 − 12 = VD 24 billion. Tax increase = 24 ÷ 3 = VD 8 billion.

Interpretation. AD shifts left. Real GDP falls back towards 600, unemployment rises towards the natural rate, and the price level falls or rises less than it otherwise would. Without the policy, Topic 3.7 tells you that rising wages would eventually close the gap through a leftward shift of SRAS, but at a higher price level.

Lags in discretionary fiscal policy

The model shows AD moving at once. In reality, discretionary fiscal policy takes time. Textbooks group and name the lags in slightly different ways, but the stages are:

Why lags matter: suppose Valdoria agrees the VD 7.5 billion spending rise from Worked example 1, but the roads are built two years later. By then, falling wages (Topic 3.7) or a recovery in exports may already have closed the gap. The extra spending would then push real GDP above Yf and add to inflation. Badly timed policy can make the business cycle worse, not better. This is one reason governments also rely on automatic stabilisers, which need no new decision (Topic 3.9).

Common misconceptions

• “Transfer payments are part of G.” They are not purchases of goods and services. They change disposable income, so they work like a tax cut, with the tax multiplier’s size.
• “Change in G needed = gap × multiplier.” Divide the gap by the multiplier: 30 ÷ 4 = 7.5, not 30 × 4.
• Using the spending multiplier for a tax change. A tax change uses the tax multiplier; with MPC 0.75 the tax cut needed is 10, not 7.5.
• “A tax cut and a spending rise of the same size have the same effect.” The spending rise has the bigger effect, because part of a tax cut is saved.
• “Expansionary policy lowers the price level.” It shifts AD right, so the price level rises in the short run.
• “Interest rate cuts are fiscal policy.” Those are monetary policy, carried out by the central bank.
• “Fiscal policy shifts SRAS or LRAS.” In this topic it works through AD.
• “Fiscal policy works immediately.” Recognition, decision, implementation and impact all take time.

Where this leads

Next, Topic 3.9, Automatic Stabilizers, shows how parts of the tax and transfer system change by themselves over the business cycle. In Unit 5 you will look at fiscal policy again: government deficits and debt (Topic 5.4) and crowding out (Topic 5.5). If the multipliers are not yet secure, go back to Topic 3.2; for the alternative of doing nothing, see Topic 3.7.

Now try the practice questions, then use the revision notes and the checklist to consolidate.