IB DP Economics: Fiscal policy – Practice Questions

These are original questions written for Marlbridge, for revision and practice on this content. They are not reproduced past-paper questions, and they do not replicate the exam’s exact structure, question count or mark tariffs – the IB holds copyright in its own papers. Use these alongside the official past papers available through your school or the IB store.

These questions follow the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. They cover sub-topic 3.6, Demand management – fiscal policy. Questions marked “HL only” cover the multiplier, crowding out and automatic stabilisers. The rest suit SL and HL. All countries and figures are invented. The [1] points in the answers are a revision aid, not IB marks.

Start with the study guide or the revision notes. Other useful pages are the IB DP Economics hub, the printable checklist and the free 10-minute diagnostics.

Questions

1. Distinguish between direct and indirect taxation, giving one example of each. [3]

2. The fictional country Tarnia reports these figures, in billions of tarns: income tax 180, corporate profits tax 70, sales tax 130, receipts from state-owned enterprises 15, sale of a government asset 25. Current expenditure is 265, capital expenditure 60 and transfer payments 95.

(a) Calculate total revenue, total expenditure and the budget balance. [3] (b) Calculate the balance if the asset sale is excluded, and comment on what this shows. [2]

3. Using an AD/AS diagram of the Keynesian view, explain how expansionary fiscal policy can close a deflationary (recessionary) gap. [5]

4. Using a diagram of the monetarist/new classical view, explain the long-run effect of expansionary fiscal policy. [5]

5. (HL only) An economy has MPC = 0.5 and no taxes or imports.

(a) Find the Keynesian multiplier. [1] (b) Investment rises by 14. Find the effect on GDP. [1] (c) Government spending falls by 5. Find the effect on GDP. [1]

6. (HL only) In the fictional country Garland, MPS = 0.2, MPT = 0.3 and MPM = 0.3.

(a) Find the value of the multiplier. [2] (b) Exports rise by 40. Find the resulting rise in GDP. [2] (c) Garland has a deflationary gap of 100. Calculate the rise in government spending that would close it. [2]

7. Explain two constraints on the effectiveness of fiscal policy other than crowding out. [4]

8. (HL only) In the fictional country Corvia the multiplier is 2. The government raises spending by 30 and borrows all of it. Private investment falls by 12 as a result.

(a) Calculate the net injection and the change in GDP. [2] (b) Using AD and AS curves, explain why investment falls and how the result differs from a case without crowding out. [3]

9. (HL only) In Corvia, income tax is 5% on the first 80 of a household’s income and 25% on income above 80. A household’s income falls from 150 to 110.

(a) Calculate the tax paid at each income. [2] (b) Calculate the change in disposable income. [1] (c) Show that a flat 10% tax would have caused a larger fall in disposable income, and state what this illustrates. [2]

10. Evaluate the use of fiscal policy to reduce unemployment in an economy in a deep recession. [10]

Answers

1. Direct tax: levied on and borne by the person or firm paying it, for example income tax [1]. Indirect tax: collected from the seller and passed on, at least partly, through prices, for example sales tax [1]. Contrast: the legal payer and the person bearing the burden are the same for direct tax but differ for indirect tax [1]. Examiner insight: “Distinguish” asks for the difference itself, so a definition of each with no stated contrast is only part of the answer.

2. (a) Revenue = 180 + 70 + 130 + 15 + 25 = 420 [1]. Expenditure = 265 + 60 + 95 = 420 [1]. Balance = 420 − 420 = 0 (a balanced budget) [1]. (b) Excluding 25: revenue 395, so balance = 395 − 420 = −25 [1]. The balance is only reached by a one-off sale, so there is an underlying deficit that may not be sustainable [1]. Examiner insight: “Calculate” asks for working to be shown, so write each sum out rather than only the totals.

3. Draw price level against real GDP, with Keynesian AS flat, then rising, then vertical at potential output [1]. Equilibrium at AD1 is at a level of output below potential, which is a deflationary gap [1]. Higher government spending or lower taxes shifts AD right to AD2 [1]. Output rises towards potential output, and unemployment falls [1]. Because AS is flat or shallow there, the price level rises little [1]. Examiner insight: A diagram with unlabelled axes or equilibria usually cannot support the explanation, so label every curve and both equilibria.

4. Draw vertical LRAS at potential output, SRAS, and AD1 meeting both at long-run equilibrium [1]. Expansionary policy shifts AD right to AD2 [1]. In the short run output rises above potential along SRAS [1]. Wages and costs rise, so SRAS shifts left [1]. The long-run equilibrium returns to potential output at a higher price level, so the policy changes prices but not output [1]. Examiner insight: The key skill is separating short-run from long-run, so state clearly which equilibrium each sentence refers to.

5. (a) Multiplier = 1 / (1 − 0.5) = 1 / 0.5 = 2 [1]. (b) 2 × 14 = 28 rise [1]. (c) 2 × (−5) = −10, a fall of 10 [1]. Examiner insight: Part (c) is only complete if the direction of the change is clear, so state a fall.

6. (a) Leakages = 0.2 + 0.3 + 0.3 = 0.8 [1]. Multiplier = 1 / 0.8 = 1.25 [1]. (b) 1.25 × 40 = 50 [1]; written as a rise in GDP [1]. (c) Required injection = 100 / 1.25 = 80 [1]. Method: gap divided by the multiplier [1]. Examiner insight: Using 1 / MPS = 5 here ignores two of the three leakages and gives a wrong answer from the start.

7. Political pressure: tax rises and spending cuts are unpopular, so a government may delay or avoid the policy that the economy needs [1]. This limits its use for contraction in a boom, for example [1]. Time lags: recognising a problem, passing the policy and spending the money take time [1]. The policy may take effect when conditions have changed, such as in a recovery, and then push up inflation [1]. (Sustainable debt is an equally valid second constraint.) Examiner insight: A named constraint alone earns little; the credit comes from explaining how it limits the policy.

8. (a) Net injection = 30 − 12 = 18 [1]. Change in GDP = 18 × 2 = 36 [1]. (b) Government borrowing competes for funds and raises interest rates, which makes investment less attractive [1]. AD first shifts right by the government spending effect, then shifts back part of the way as investment falls [1]. Without crowding out GDP would rise by 30 × 2 = 60, so the policy is weaker by 24 [1]. Examiner insight: A crowding-out answer should link borrowing to interest rates to investment, because skipping a link leaves the argument incomplete.

9. (a) Tax at 150 = 0.05 × 80 + 0.25 × 70 = 4 + 17.5 = 21.5 [1]. Tax at 110 = 4 + 0.25 × 30 = 4 + 7.5 = 11.5 [1]. (b) Disposable income: 150 − 21.5 = 128.5 and 110 − 11.5 = 98.5, so it falls by 30 [1]. (c) Flat 10%: disposable income 135 and 99, a fall of 36, which is more than 30 [1]. This illustrates an automatic stabiliser: a progressive tax cushions the fall in spending power without any new government decision [1]. Examiner insight: “Show that” needs the intermediate values for both taxes, since the conclusion depends on comparing them.

10. Indicative points, one for each. This is a plan; real papers are marked against the IB markbands, not point by point. Expansionary policy shifts AD right and raises output and employment [1]. In a deep recession private spending is weak, so government spending adds demand directly [1]. Spending can be targeted at sectors or regions with high unemployment [1]. Extra spending is spent again in further rounds, raising the effect (HL only) [1]. Time lags may delay the effect past the recession [1]. Borrowing raises debt and interest costs, which may limit sustainable action [1]. Political pressure may favour popular tax cuts over better-targeted spending [1]. Crowding out may weaken the effect (HL only) [1]. Fiscal policy mainly helps cyclical unemployment; the monetarist/new classical view sees long-run effects on prices, and skills mismatches need supply-side policy [1]. A justified overall judgment, such as that fiscal policy is most effective when the recession is deep and debt is manageable [1]. Examiner insight: An evaluation answer does better with a conclusion that weighs the points against this economy than with a longer list of unconnected points.

Where marks are usually lost

• Writing totals without showing the sums in “calculate” questions.
• Giving the budget balance without saying whether it is a surplus or deficit.
• Using the simple multiplier when MPT and MPM are given.
• Forgetting to multiply the multiplier by the injection.
• Diagrams without axes, curve names or labelled equilibria.
• Mixing the Keynesian and monetarist/new classical models in one explanation.
• Naming a constraint without explaining how it limits policy.
• Ending an evaluation with no overall judgment.

Next steps

• Review the revision notes and the study guide.
• Go to the IB DP Economics hub and tick off the printable checklist.
• Compare with monetary policy and supply-side policies in the same course.
• Try all free 10-minute diagnostics.
• Book a free trial class.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published by the International Baccalaureate Organization (February 2020), sub-topic 3.6 Demand management – fiscal policy.