Cambridge IGCSE Economics: Fiscal policy measures and monetary policy (0455)

This guide follows the Cambridge IGCSE Economics 0455 syllabus for examination in 2026, version 2. It covers sections 4.3.7 to 4.3.9 (the second half of fiscal policy) and 4.4.1 to 4.4.3 (monetary policy). The first half of fiscal policy, 4.3.1 to 4.3.6 on the budget, spending and taxes, is taught separately and is not repeated here. The syllabus is not tiered, and it notes that aggregate demand and aggregate supply are not required for 4.3.9. Every country, firm and figure below is invented and illustrative.

Links: the Cambridge IGCSE Economics hub, the printable checklist, the revision notes, the practice questions, the exam preparation page and the free diagnostics.

What this unit covers

Section	What you must be able to do
4.3.7	Define fiscal policy
4.3.8	Explain tax and spending changes that cause budget balance or imbalance; calculate a deficit or surplus
4.3.9	Explain how fiscal measures help a government reach its macroeconomic aims
4.4.1	Define money supply and monetary policy
4.4.2	Explain changes in interest rates, money supply and foreign exchange rates
4.4.3	Explain how monetary measures help a government reach its macroeconomic aims

The five macroeconomic aims from section 4.2 are growth, low unemployment, low inflation, a stable balance of payments and a fairer income distribution. Every effect in this unit is judged against them.

4.3.7 What fiscal policy is

Fiscal policy is the use of government spending and taxation to influence the economy and help achieve the government’s macroeconomic aims.

There are only two levers: what the government spends and what it collects in tax. A change in either is fiscal policy.

• Expansionary (or reflationary) fiscal policy: lower taxes, higher spending, or both. It aims to raise spending in the economy.
• Contractionary (or deflationary) fiscal policy: higher taxes, lower spending, or both. It aims to reduce spending in the economy.

4.3.8 Measures and the budget balance

Budget balance = government revenue − government spending.

Result	Meaning
Revenue > spending	Budget surplus
Revenue < spending	Budget deficit
Revenue = spending	Balanced budget

A deficit must be financed, usually by borrowing, which adds to the national debt. A surplus can pay off debt, build reserves or fund extra spending later.

Worked example 1: finding the balance

Country A (illustrative) has these planned figures, in units of currency (billions).

Revenue		Spending
Income tax	42	Health	28
Sales tax	31	Education	22
Corporation tax	18	Welfare payments	30
Other	9	Defence	8
		Infrastructure	17
		Interest on debt	5
Total	100	Total	110

Balance = 100 − 110 = −10. This is a deficit of 10. If national output is 800, the deficit is 10 ÷ 800 × 100 = 1.25% of output.

How fiscal measures change the balance

Work out the direct effect first, then say what else may change.

Tax cut. Income tax raises 42 at a rate of 20% on a taxable base of 210 (42 = 0.20 × 210). The government cuts the rate to 18%.

• New yield if the base stays at 210: 0.18 × 210 = 37.8. Revenue falls by 4.2, so the deficit rises from 10 to 14.2.
• Suppose lower tax encourages more work and the base grows to 224. Yield = 0.18 × 224 = 40.32. Revenue falls by only 1.68 and the deficit is 11.68.

The second case shows why the real effect of a tax cut on revenue can be smaller than the arithmetic suggests. It is not guaranteed.

Tax rise. The sales tax rate rises from 10% to 12% on a spending base of 310. Yield rises from 31 to 37.2, a gain of 6.2. The deficit falls from 10 to 3.8, provided buyers do not cut their purchases enough to shrink the base.

Spending rise. An extra 10 on infrastructure with revenue unchanged raises spending to 120, so the deficit doubles to 20.

Spending cut. Spending on one area falls by 6 with revenue unchanged: the deficit falls to 4.

A tax cut paired with a spending rise widens a deficit. A tax rise paired with a spending cut narrows it or creates a surplus. If a government raises both tax and spending by the same amount, the balance does not change, but the economy is still affected.

Types of spending matter. Capital spending (roads, schools) can raise the economy’s capacity to produce. Current spending (wages, running costs) and transfers (welfare payments) are spent each year.

4.3.9 Effects of fiscal policy on macroeconomic aims

Describe the chain, one step at a time, in the economy’s own terms (incomes, spending, firms, jobs, prices). You do not need aggregate demand or aggregate supply.

Aim	Expansionary measure	Contractionary measure
Economic growth	More spending and lower tax raise household and firm spending, so firms produce more	Higher tax and lower spending slow growth
Employment	Firms facing more orders hire; road building employs workers directly	Fewer orders, fewer jobs
Stable prices	May push prices up if firms cannot produce more	Lower spending eases price pressure
Balance of payments	Higher incomes pull in more imports, so the current account can worsen	Lower income reduces imports
Redistribution	Progressive taxes and transfers narrow the gap between rich and poor	Cutting transfers or raising regressive taxes widens it

Chain of reasoning: spending to employment

The government spends 10 on a road programme. Construction firms hire workers and buy materials. Those workers and suppliers earn more and spend more in shops. Shops sell more and hire. Unemployment falls and output grows. If the economy is already fully employed, firms compete for labour and materials and prices rise instead.

Worked example 2: redistribution

Country B (illustrative) taxes income above an allowance at 20% in a progressive system. Compare two workers with an allowance of 10.

Income	Taxable	Tax at 20%	Tax as % of income
20	10	2	10%
50	40	8	16%

The higher earner pays a larger share of income. Because the share rises with income, the tax is progressive. Spending the revenue on health care and welfare for low-income households narrows the gap further.

Evaluating fiscal policy

• Time lags. Building projects take time to plan; the economy may have changed by the time they spend.
• Opportunity cost and debt. A deficit means borrowing and later interest, which reduces spending on other things.
• Spare capacity. Extra spending raises output only if firms have unused resources; otherwise prices rise.
• Imports. Part of any extra income is spent abroad.
• Conflicts. A policy that cuts unemployment can raise inflation or worsen the balance of payments.
• Politics. Tax rises and spending cuts are unpopular, so they may be delayed.

4.4.1 Money supply and monetary policy

The money supply is the total amount of money in an economy, including notes and coins and the deposits people hold in banks that they can spend.

Monetary policy is the use of interest rates, the money supply and the foreign exchange rate to influence the economy and help achieve the government’s macroeconomic aims. It is usually carried out by the central bank, either independently or on the government’s behalf.

4.4.2 Monetary policy measures

Changes in interest rates

The interest rate is the price of borrowing and the reward for saving. When the central bank changes its main rate, banks usually change the rates they charge borrowers and pay savers.

Higher rate: borrowing is dearer, saving is more rewarding, households and firms spend and invest less. Lower rate: the opposite.

Worked example 3. A firm borrows 200,000 (illustrative). At 5% interest costs 10,000 a year; at 7% they cost 14,000, which is 4,000 more. A project expected to earn 12,000 a year is worth doing at 5% (a gain of 2,000) but not at 7% (a loss of 2,000). Higher rates cancel some investment.

On the other side, a saver with 10,000 earns 200 at 2% and 400 at 4%.

Changes in the money supply

The central bank can raise the money supply by buying government bonds from banks and others (paying with newly created money), or by reducing the cash banks must hold in reserve, so they can lend more. Selling bonds or raising reserve requirements reduces it. A larger supply makes credit easier to obtain and usually lowers interest rates; a smaller supply does the reverse.

Changes in the foreign exchange rate

The exchange rate is the price of one currency in terms of another. Governments may influence it by changing interest rates (higher rates attract foreign savers, who must buy the currency first, so its value tends to rise) or by buying and selling currency.

Worked example 4. Country A’s currency is the A-dollar. At the start, 1 A-dollar = 0.50 B-units. An A-made good costs 40 A-dollars. Its price in B-units is 40 × 0.50 = 20.

The A-dollar rises to 1 A-dollar = 0.80 B-units, an appreciation of (0.80 ÷ 0.50 − 1) × 100 = 60%.

• The same export now costs 40 × 0.80 = 32 B-units, a rise of 60%.
• A B-made good priced at 24 B-units cost 24 ÷ 0.50 = 48 A-dollars, and now costs 24 ÷ 0.80 = 30 A-dollars, a fall of 37.5%.

Exports become dearer abroad and imports cheaper at home. A fall in the rate (depreciation) does the reverse.

4.4.3 Effects of monetary policy on macroeconomic aims

Aim	Lower interest rate / easier money / lower exchange rate	Higher interest rate / tighter money / higher exchange rate
Economic growth	Cheaper borrowing raises consumption and investment; cheaper exports raise sales abroad	Dearer borrowing slows both; dearer exports reduce sales
Employment	More output needs more workers	Falling sales reduce hiring
Stable prices	Risk of rising prices if spending outruns supply	Lower spending and cheaper imports reduce price rises
Balance of payments	A lower exchange rate helps exports and discourages imports	A higher rate hurts exports and encourages imports
Redistribution	Weak tool; borrowers gain, savers lose	Savers gain, borrowers lose

Evaluating monetary policy

• Time lags. Borrowers take months to respond to a rate change.
• Pass-through. Banks may not change their own rates by the same amount.
• Confidence. If households and firms expect poor sales, cheaper loans may not tempt them to borrow.
• Exchange-rate effect. A lower rate for growth may also lower the exchange rate, raising import prices and inflation.
• Elasticity. A weaker currency only improves the balance of payments if demand for exports and imports is price elastic enough.
• Conflicts. Cutting rates to cut unemployment can raise inflation.

Fiscal and monetary policy compared

	Fiscal	Monetary
Who	Government	Central bank (often)
Levers	Tax, spending	Interest rate, money supply, exchange rate
Direct effect on budget	Yes	Mainly through interest on debt
Direct redistribution	Strong	Weak

Common errors

• Writing the budget balance as spending − revenue and getting the sign wrong.
• Saying a tax cut always lowers revenue by the full arithmetic amount.
• Describing “more demand” without saying whose spending rises and why.
• Treating a higher interest rate as a rise in the money supply.
• Confusing an appreciation, which raises export prices abroad, with a depreciation.
• Judging a policy without naming a limit, such as a time lag or a conflicting aim.

Official syllabus

Cambridge IGCSE Economics 0455 syllabus for examination in 2026, version 2, published by Cambridge University Press & Assessment: sections 4.3.7 to 4.3.9 and 4.4.1 to 4.4.3.