Cambridge A Level Economics: Effectiveness of fiscal and monetary policy including the Laffer curve (9708)

This guide covers part of outcome 10.3.1 (fiscal policy including Laffer curve analysis, and monetary policy), plus 10.3.2 and 10.3.3, in the Cambridge International AS & A Level Economics 9708 syllabus for examination in 2026, 2027 and 2028. The syllabus states that topics 1 to 6 are AS Level content and topics 7 to 11 are A Level content. Topic 10 is therefore A Level only and is not examined at AS. Supply-side, exchange rate and trade policies sit in a separate unit. All countries, firms and figures below are invented, and money is in zu (illustrative currency units).

Build on the AS fiscal policy guide and the AS monetary policy guide. Then use the revision notes and the practice set. Track progress on the Cambridge A Level Economics hub, the checklist and a free 10-minute diagnostic.

What this unit asks of you

Outcome	What you must be able to do
10.3.1 fiscal policy	Judge how far tax and spending changes achieve each macroeconomic objective, using Laffer curve analysis
10.3.1 monetary policy	Judge how far interest rates, the money supply and related tools achieve each objective
10.3.2	Explain problems and conflicts that follow from the outcomes of these policies
10.3.3	Explain how macroeconomic policy can fail

Section C of Paper 4 holds the macroeconomic essays, and the syllabus says answers there should show evidence of evaluation. “Effectiveness” is therefore the key word. For any policy, ask which objective, how big the effect is, how fast, how certain, and at what cost.

Fiscal policy: the tools and the multiplier

Fiscal policy changes government spending, taxation and the budget balance. Expansionary fiscal policy raises aggregate demand (AD). Contractionary policy lowers it.

The size of the effect depends on the multiplier. With marginal propensities to save (s), be taxed (t) and import (m), each as a fraction of extra income:

multiplier k = 1 / (s + t + m)

Worked example 1: a spending increase in Country Z

Country Z has s = 0.10, t = 0.20 and m = 0.20. Actual output is 940 zu bn and potential output is 1,000 zu bn.

1. Withdrawals from each extra unit of income: 0.10 + 0.20 + 0.20 = 0.50.
2. k = 1 / 0.50 = 2.
3. The government raises spending by 20. Change in output = 2 × 20 = 40.
4. Tax revenue rises by 0.20 × 40 = 8, so the budget deficit rises by only 20 − 8 = 12.
5. The output gap is 60, so the injection needed to close it is 60 / 2 = 30. The 20 closes two thirds of the gap.

Crowding out

If the government borrows to fund the spending, the demand for loanable funds rises and interest rates may rise. Suppose private investment falls by 6 as a result.

1. Net injection = 20 − 6 = 14.
2. Change in output = 2 × 14 = 28, not 40.
3. Extra tax revenue = 0.20 × 28 = 5.6, so the deficit rises by 20 − 5.6 = 14.4.
4. The gap is still 60 − 28 = 32.

Crowding out is likely to be small when there is spare capacity and the central bank holds interest rates down, and larger near full employment.

Fiscal policy: the Laffer curve

The Laffer curve shows tax revenue against the tax rate. At a 0% rate revenue is zero. At 100% revenue is assumed to be zero because nobody has an incentive to earn taxable income. Revenue rises, reaches a maximum at some rate, then falls.

Two forces act when the rate rises. The arithmetic effect raises revenue from each unit of income. The behavioural effect shrinks the tax base, through less work effort, more avoidance and evasion, and some skilled workers moving abroad.

Worked example 2: a Laffer curve for Country Z

Suppose the taxable income base (zu bn) is 400 − 4t, where t is the income tax rate in per cent. Revenue = t × base / 100.

Tax rate (%)	Base	Revenue
20	320	64
30	280	84
40	240	96
50	200	100
60	160	96
70	120	84
80	80	64

The peak is at 50%, with revenue of 100.

• A cut from 70% to 60% raises revenue from 84 to 96, a rise of 12 (14.3%). The government is on the downward-sloping part, so a cut helps revenue.
• A cut from 40% to 30% lowers revenue from 96 to 84, a fall of 12 (12.5%). The government is on the upward-sloping part, so a cut loses revenue.

Evaluating Laffer analysis

• The peak rate cannot be observed. The numbers above are assumed. In practice it differs by country, by tax and over time.
• The curve is about revenue. A government may care about incentives, growth or equity instead, and a lower rate can raise output even if it lowers revenue.
• A cut on the downward-sloping part is rarely a free lunch in the short run. The behavioural response takes time, so revenue may fall first.
• Evasion and avoidance respond to how easy it is to hide income, so the curve differs by tax type.
• Rates beyond the peak are hard to justify on revenue grounds, but a government may still tax at a high rate for redistribution.

Fiscal policy against each objective

Objective	Likely effect of expansionary fiscal policy	Main limit
Economic growth	AD rises, so actual growth rises when there is spare capacity	Little effect on long-run capacity unless spending is on capital or education
Unemployment	Cyclical unemployment falls as output rises	Structural unemployment is untouched
Inflation	Contractionary policy cuts demand-pull pressure	No effect on cost-push inflation, and cuts are politically hard
Balance of payments	Contractionary policy cuts import spending	Expansion raises imports and worsens the current account
Redistribution	Progressive taxes and transfers narrow gaps	High marginal rates may reduce effort
Sustainability	Taxes and subsidies can change behaviour	Revenue needs can conflict with falling use of the taxed item
Development	Spending on health, education and infrastructure raises living standards and capacity	Limited tax base, and waste or corruption can reduce the benefit

Automatic stabilisers help here, because tax revenue rises in a boom and falls in a slump without any decision. Discretionary changes need to be chosen, which takes time.

Worked example 3: the debt burden

Country Z has national debt of 800 and nominal GDP of 1,000, a ratio of 80%. It runs a deficit of 50, so debt becomes 850. If nominal GDP grows 4% to 1,040, the ratio is 850 / 1,040 = 81.7%. If nominal GDP grows 6% to 1,060, the ratio is 80.2%. Faster growth slows the rise in the burden, but a deficit still adds debt.

Monetary policy: the tools and transmission

Monetary policy is run by the central bank. Its tools are the policy interest rate, control of the money supply (including quantitative easing) and, in some countries, credit regulation.

The interest rate channel

A higher policy rate leads to:

1. higher borrowing costs, so less consumption and investment;
2. a higher return on saving, so more saving;
3. a rise in the exchange rate if money flows in, which makes exports dearer and imports cheaper;
4. lower AD, lower demand-pull inflation, and lower growth.

Worked example 4: a rate rise in Country Z

A household has a 150,000 zu variable-rate loan. The rate rises from 4% to 6%.

1. Interest before = 150,000 × 0.04 = 6,000.
2. Interest after = 150,000 × 0.06 = 9,000.
3. Extra cost = 3,000, a rise of 50%.

The real rate matters too. With inflation at 2.5%, the real interest rate is about 6 − 2.5 = 3.5%.

Now suppose output is 1,030, which is 30 above potential. The rise cuts consumption and investment by 12 in total. With k = 2, output falls by 24, to 1,006. The inflationary gap is nearly closed.

Quantitative easing

In quantitative easing the central bank creates money to buy bonds. Bond prices rise and yields fall. A bond paying 5 zu a year that costs 100 yields 5%. If its price rises to 125 the yield is 5/125 = 4%. Lower yields cut longer-term borrowing costs and raise asset prices, which can lift spending when the policy rate is already near zero.

Monetary policy against each objective

Objective	Likely effect	Main limit
Inflation	Strong against demand-pull inflation	Weak against cost-push inflation and subject to a lag
Growth	Lower rates raise investment and consumption	Low confidence can make demand unresponsive to rates
Unemployment	Cyclical unemployment falls as AD rises	No effect on structural unemployment
Balance of payments	Higher rates raise the exchange rate and may widen a deficit	Lower rates may help exports but raise inflation
Redistribution	Weak and unintended	Savers and borrowers gain and lose differently
Sustainability and development	Little direct effect, though stable prices and cheap credit can support investment	A blunt tool, because it cannot target particular sectors or groups

Problems and conflicts (10.3.2)

• Growth against the balance of payments. Suppose imports are 300 and the income elasticity of demand for imports is 1.8. Growth of 3% lifts imports by 1.8 × 3 = 5.4%, to 316.2. If exports of 280 rise 2% to 285.6, the trade balance moves from −20 to −30.6.
• Inflation against unemployment. Contractionary policy that cuts inflation can raise unemployment.
• Growth against sustainability. Faster output growth may increase resource use and pollution.
• Redistribution against incentives. Higher top tax rates fund transfers but may reduce effort.
• Deficit against recovery. Cutting a deficit in a slump may lower AD further.
• Policy mix. Tight monetary policy with loose fiscal policy pushes interest rates up, may crowd out investment and may lift the exchange rate.
• Time lags. Policy can take effect after the problem has changed.

Government failure (10.3.3)

Government failure exists when intervention leaves the economy worse off or does less well than expected.

• Information failure. Forecasts of the output gap are uncertain, so policy can be too much or too little.
• Time lags. A stimulus decided in a slump may arrive in a boom and add to instability.
• Political motives. Spending rises and taxes fall before elections.
• Conflicting objectives. Meeting one target worsens another.
• Unintended consequences. High tax rates encourage evasion. Low rates can inflate asset prices.
• Crowding out. Public borrowing displaces private investment.
• Weak independence. If the central bank is pressed to finance the deficit, inflation may rise.

A method for an evaluation answer

1. Name the objective and the policy.
2. Give a short chain of reasoning, with a diagram described in words if it helps.
3. Judge size, speed and certainty using the data given.
4. Weigh the main costs and conflicts.
5. State a conclusion that depends on stated conditions, such as spare capacity or the cause of inflation.

Common errors

• Treating the Laffer curve as proof that tax cuts raise revenue.
• Using a multiplier that ignores taxes and imports.
• Saying monetary policy cures cost-push inflation.
• Describing conflicts without saying which objective gains and which loses.
• Listing government failures without linking them to a named policy.

Official syllabus

Cambridge International AS & A Level Economics 9708 syllabus, for examination in 2026, 2027 and 2028, version 2, published by Cambridge University Press & Assessment. This guide covers part of outcome 10.3.1 and outcomes 10.3.2 and 10.3.3.