Cambridge International AS and A Level Economics: Macroeconomic objectives and fiscal policy (9708)

This guide covers sections 5.1 and 5.2 of the Cambridge International AS and A Level Economics (9708) syllabus for examination in 2026, 2027 and 2028: government macroeconomic policy objectives (5.1.1) and fiscal policy (5.2.1 to 5.2.7). Topics 1 to 6 are AS Level content, and this unit is assumed knowledge for A Level Papers 3 and 4. Every country, firm and figure here is invented for illustration, and money is in currency units (cu). For quick recall use the revision notes, then try the practice questions. See also the course hub, the checklist and the diagnostics. You need the AD/AS model from section 4.3, covered in the AD and AS guide.

What this unit covers

Section	What you must be able to do
5.1.1	Explain how government policy can be used to pursue price stability, low unemployment and economic growth. Policy conflicts and trade-offs are not required
5.2.1	Explain what a government budget is
5.2.2	Distinguish a budget deficit from a budget surplus
5.2.3	Explain the meaning and significance of the national debt
5.2.4	Taxes: direct and indirect, progressive, regressive and proportional; marginal and average rates; reasons for taxation
5.2.5	Spending: capital and current; reasons for government spending
5.2.6	Distinguish expansionary from contractionary fiscal policy
5.2.7	Use AD/AS to show the effect on equilibrium national income, real output, the price level and employment

5.1.1 Policy objectives

A government has three macroeconomic objectives in this unit.

• Price stability: low and steady inflation, so that the price level is predictable. The aim is usually a low target rate.
• Low unemployment: few people who are able, willing and looking for work are without a job.
• Economic growth: a rise in real GDP over time.

Three types of policy can pursue these objectives: fiscal policy (the budget, this unit), monetary policy (interest rates and the money supply, section 5.3) and supply-side policy (section 5.4). Fiscal measures link to each objective as follows.

Objective	Typical problem	Fiscal response
Price stability	Demand-pull inflation	Lower government spending or higher taxes, so AD grows more slowly
Low unemployment	Cyclical unemployment in a recession	Higher spending or lower taxes, so AD rises and firms hire
Economic growth	Slow growth in output	Short run: raise AD. Long run: capital spending and tax incentives that raise capacity

Worked example: checking progress on the objectives

Country A has a target inflation rate of 2%. The consumer price index (CPI) rises from 104.0 to 106.6.

Inflation = (106.6 − 104.0) ÷ 104.0 × 100 = 2.5%, which is above target.

Nominal GDP rises by 6.3% while prices rise by 2.5%. Real growth is 1.063 ÷ 1.025 − 1 = 0.0371, so real GDP grows by 3.7%. Dividing by the price index removes the price effect; subtracting 2.5 from 6.3 gives 3.8, which is only an approximation.

The labour force is 32 million and 1.6 million are unemployed. The unemployment rate = 1.6 ÷ 32 × 100 = 5.0%. If 0.8 million more people find work and the labour force stays the same, the rate falls to 0.8 ÷ 32 × 100 = 2.5%.

5.2.1 and 5.2.2 The budget: deficit and surplus

The government budget is the plan of government revenue and government spending for a period, usually a year. Revenue comes mainly from taxes. Spending covers current items and capital items.

• Budget deficit: spending is greater than revenue. The government must borrow the difference.
• Budget surplus: revenue is greater than spending. The government can repay debt or build up reserves.
• Balanced budget: revenue equals spending.

Worked example: Country A’s budget (cu billion)

Revenue		Spending
Income tax	310	Current	560
Corporation tax	90	Capital	130
Sales tax	150
Excise duties	60
Other	40
Total	650	Total	690

Budget balance = 650 − 690 = −40, a deficit of 40. With GDP of 2,600, the deficit is 40 ÷ 2,600 × 100 = 1.5% of GDP. Direct taxes (income and corporation) are 400 ÷ 650 = 61.5% of revenue.

Next year revenue is 700 and spending 680. The balance is +20, a surplus.

In a recession a deficit can widen without a policy change, because tax receipts fall and benefits rise.

5.2.3 The national debt

The national debt is the total amount the government owes, built up from past borrowing. A deficit is a flow in one year; the debt is a stock that adds up those flows. A surplus used to repay lenders reduces the debt.

Country A starts the year owing 900. After a deficit of 40 the debt is 900 + 40 = 940, which is 940 ÷ 2,600 × 100 = 36.2% of GDP. The ratio matters more than the raw sum. If the next year ends with a surplus of 20 that is used to repay lenders, the debt falls to 920.

Why the debt matters (its significance):

• Interest payments are an opportunity cost. At an average interest rate of 3.5% the bill is 0.035 × 940 = 32.9 cu billion, or 5.1% of revenue. That money cannot go to schools or roads.
• Future taxes may need to rise, or other spending fall, to pay lenders.
• Debt owed to foreign lenders sends interest abroad. Debt owed to domestic lenders stays in the economy.
• A large, rising debt can make lenders ask for higher interest.

5.2.4 Taxation

Types

• Direct tax: levied on the income or profit of the person or firm that pays it to the government, such as income tax or corporation tax.
• Indirect tax: added to the price of purchases and handed over by the seller, such as a sales tax or an excise duty.

By how the tax burden changes with income:

• Progressive: the tax takes a higher proportion of income as income rises.
• Proportional: the same proportion at all incomes.
• Regressive: a lower proportion as income rises.

Marginal and average rates

• Average rate of taxation (art) = total tax ÷ total income × 100.
• Marginal rate of taxation (mrt) = change in tax ÷ change in income × 100. It is the rate on the next unit of income.

A tax is progressive when the average rate rises with income, which happens when the marginal rate is above the average rate.

Worked example: Country A’s income tax

The first 10,000 cu of income is taxed at 0%. Income from 10,000 to 40,000 is taxed at 20%. Income above 40,000 is taxed at 40%.

Income	Tax	Average rate	Marginal rate
10,000	0	0%	20% on the next unit
25,000	3,000	12.0%	20%
40,000	6,000	15.0%	20% up to 40,000
60,000	14,000	23.3%	40%
100,000	30,000	30.0%	40%

At 60,000: tax = 0.20 × 30,000 + 0.40 × 20,000 = 6,000 + 8,000 = 14,000. Average rate = 14,000 ÷ 60,000 = 23.3%; the marginal rate is 40%. The average rate climbs as income climbs, so the tax is progressive.

Regressive and proportional examples

• Proportional: a flat 15% on all income takes 3,000 from 20,000 and 9,000 from 60,000, which is 15% of each.
• Regressive: a fixed annual licence fee of 120 takes 120 ÷ 20,000 = 0.6% of one income and 120 ÷ 60,000 = 0.2% of another.
• Indirect taxes can be regressive in effect. Household P (income 20,000) spends 16,000 on taxed goods and pays 10% of that, which is 1,600 or 8% of income. Household R (income 80,000) spends 40,000 on taxed goods, pays 4,000, and loses 5% of income. The rate is the same, but the burden is heavier on the poorer household because it spends more of its income.

Reasons for taxation

• Raise revenue to pay for spending.
• Redistribute income, using progressive taxes.
• Discourage demerit goods or activities with negative externalities, by raising their price.
• Influence aggregate demand as part of fiscal policy.

5.2.5 Government spending

• Current spending is on goods and services used up in the year: wages of public employees, benefits, debt interest, and day-to-day running costs.
• Capital (investment) spending adds to the stock of assets that last: roads, schools, hospitals, power lines.

In Country A capital spending is 130 ÷ 690 × 100 = 18.8% of the total.

Reasons for government spending:

• Provide public goods and merit goods that markets under-provide.
• Redistribute income through benefits and subsidised services.
• Support growth by building infrastructure and funding education, which raise productive capacity.
• Influence aggregate demand, to move output toward full employment.

5.2.6 Expansionary and contractionary fiscal policy

• Expansionary fiscal policy raises AD by increasing government spending, cutting taxes, or both. It usually makes a deficit larger or a surplus smaller.
• Contractionary fiscal policy lowers AD by cutting spending, raising taxes, or both. It usually makes a deficit smaller or a surplus larger.

A rise of 60 in spending takes Country A’s deficit from 40 to 100 before any feedback, because higher output would bring in some extra tax.

5.2.7 AD/AS analysis

Country A has AD: Y = 1,800 − 6P and short-run aggregate supply SRAS: Y = 600 + 6P, with Y in cu billion and P an index. Full employment output is 1,300, and SRAS becomes vertical there. Equilibrium: 1,800 − 6P = 600 + 6P, so P = 100 and Y = 1,200. Assume each worker produces 40,000 cu a year, so employment = Y ÷ 40 = 30 million.

1. Expansionary policy with spare capacity. Spending rises by 60, shifting AD to Y = 1,860 − 6P. Then 1,260 = 12P, so P = 105 and Y = 1,230.

• Prices up 5.0%, real output up 2.5%, employment 1,230 ÷ 40 = 30.75 million, a rise of 0.75 million.

2. Expansionary policy at full employment. A rise of 240 gives AD: Y = 2,040 − 6P. The intersection with the vertical part of SRAS is Y = 1,300, so P = (2,040 − 1,300) ÷ 6 = 123.3. Output rises only 8.3% (to capacity), but prices rise 23.3%.

3. Contractionary policy. Spending falls by 90, shifting AD to Y = 1,710 − 6P. Then 1,110 = 12P, so P = 92.5 and Y = 1,155. Prices fall 7.5%, output falls 3.75%, and employment falls by 1.125 million.

Chain of reasoning (expansionary): spending rises, so AD shifts right; with spare capacity firms raise output and hire, so output and employment rise with a small price rise; tax receipts rise, partly offsetting the larger deficit.

Tax cut or spending rise? If households spend 70% of extra income, a tax cut of 100 raises AD by 70 at first, whereas spending of 100 raises it by the full 100. The tax cut shifts AD to Y = 1,870 − 6P, giving P = 105.8 and Y = 1,235; the spending rise gives AD: Y = 1,900 − 6P, so P = 108.3 and Y = 1,250.

Evaluation

• Spare capacity: nearer full employment, more of the effect falls on prices.
• Time lags: spending takes time to plan and to build.
• Leakages: saving and imports reduce the rise in demand.
• Debt: a larger deficit adds to the national debt and later interest.
• Capital spending may shift long-run supply, helping growth without raising inflation.
• Judgement: expansion suits cyclical unemployment; contraction suits demand-pull inflation.

Common errors

• Confusing the deficit (one year) with the national debt (accumulated stock).
• Calling a tax progressive because the amount of tax rises with income. It must take a higher proportion.
• Using the marginal rate when asked for the average rate.
• Shifting AD the wrong way, or showing a price rise when the economy has plenty of spare capacity.

Official syllabus

Cambridge International, Cambridge International AS & A Level Economics (9708) syllabus for examination in 2026, 2027 and 2028, Subject content, section 5 Government macroeconomic intervention (AS Level), sections 5.1 and 5.2, with the AD/AS model from section 4.3.