IB DP Economics: Fiscal policy – Revision Notes

These notes 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. Most is SL and HL. The multiplier, crowding out and automatic stabilisers are HL only. For full explanations, read the study guide.

Other pages: the practice questions, the IB DP Economics hub, the printable checklist and the free 10-minute diagnostics. All countries and numbers below are invented. For the other demand-side and supply-side tools, see monetary policy and supply-side policies.

Definitions to know

Term	Meaning
Fiscal policy	Changing government spending and taxes to steer demand and the economy
Direct tax	Paid by the person or firm it is levied on (income tax, corporate profits tax)
Indirect tax	Collected from sellers and passed on in prices (sales tax)
Current expenditure	Day-to-day running costs of government
Capital expenditure	Spending on lasting assets such as roads and schools
Transfer payment	Money passed to recipients with no output produced in return
Budget balance	Revenue minus expenditure; negative is a deficit
Expansionary policy	Higher spending, lower taxes, or both; AD moves right
Contractionary policy	Less spending and/or higher taxes; shifts AD left
Deflationary (recessionary) gap	Actual output below potential output
Inflationary gap	Actual output above potential output

Four sources of revenue: direct taxes, indirect taxes, sales of goods and services by state-owned enterprises, and sale of government assets (usually one-off).

Six goals of fiscal policy

1. Low and stable inflation.
2. Low unemployment.
3. A stable environment for long-term growth.
4. Reduced business cycle fluctuations.
5. A fairer distribution of income.
6. External balance.

Goals can conflict. A boost to demand that cuts unemployment may push up inflation or imports.

Goal	Example action
Low unemployment	Raise government spending in a slump
Low inflation	Cut spending or raise taxes in a boom
Fairer income distribution	Progressive taxes and transfer payments
Long-term growth	Capital spending on infrastructure, stable tax rules
External balance	Restrain spending on imports, or support exports

Diagram method

Keynesian

1. Axes: price level and real GDP.
2. Draw AS flat, then rising, then vertical at potential output.
3. Put AD1 on the flat part, left of potential output.
4. Shift to AD2 for expansion. Output rises with little price rise.
5. For contraction, start with AD past potential output on the steep part and shift left.

Monetarist/new classical

1. Draw vertical LRAS at potential output and rising SRAS.
2. Start at long-run equilibrium.
3. Expansion: AD shifts right, and output rises above potential in the short run.
4. Costs rise, SRAS shifts left, and output returns to potential at a higher price level.
5. Contraction works the same way in reverse.

Difference to state: the Keynesian view allows an equilibrium below full employment to persist and so supports policy action. The monetarist/new classical view expects automatic return to potential output and so sees fiscal policy changing mainly prices in the long run.

Budget arithmetic reminder

Orsland’s revenue is 320 and expenditure is 345, so the balance is 320 − 345 = −25. If 20 of the revenue came from selling a state asset, the underlying position is 300 − 345 = −45. One-off receipts flatter the balance, so strip them out when judging whether a deficit is sustainable.

Multiplier (HL only)

Form	Formula	Use when
Simple	1 / (1 − MPC)	Saving is the only leakage
Full	1 / (MPS + MPT + MPM)	Tax and imports also leak

Change in GDP = multiplier × change in injection. Injections are investment, government spending and exports.

Checking the form: with MPC = 0.9 and no tax or imports, the simple form gives 1 / 0.1 = 10. In an economy where the same extra income is also taxed and spent on imports, leakages are larger and the real multiplier is much smaller. Always use every leakage the question gives.

Method in steps:

1. Add the leakages.
2. Divide 1 by the sum.
3. Multiply by the injection.
4. Give the unit and the direction of the change.

Worked reminder. Orsland has MPS = 0.10, MPT = 0.10 and MPM = 0.30.

Leakages   = 0.10 + 0.10 + 0.30 = 0.50
Multiplier = 1 / 0.50 = 2
Government spending +30  ->  GDP +60
Exports +18              ->  GDP +36
Gap of 50 needs an injection of 50 / 2 = 25

Effectiveness

	Point	One-line explanation
Constraint	Political pressure	Tax rises and cuts are unpopular, so needed contraction may be avoided
Constraint	Time lags	Recognition, decision and spending delays can bring the policy too late
Constraint	Sustainable debt	Deficits raise debt and interest costs, shrinking future room to act
Constraint (HL only)	Crowding out	Borrowing raises interest rates and cuts private investment
Strength	Targeting	Spending can be aimed at specific sectors or regions
Strength	Deep recession	Government spending adds demand when private spending will not respond
Stabiliser (HL only)	Progressive taxes, unemployment benefits	Soften swings with no new decision

Crowding out, worked reminder (HL only): government spending rises by 16 and is fully borrowed. Private investment falls by 6. Net injection = 16 − 6 = 10. With a multiplier of 2, GDP rises by 20, not the 32 that ignoring crowding out gives. On the diagram, AD shifts right, then part of the way back.

Automatic stabilisers (HL only): they act with no new decision, so they avoid the lags of discretionary policy. They are weaker than a deliberate stimulus in a deep slump, because they only soften the fall.

Judging effectiveness, by objective:

• Growth: capital spending raises capacity, and demand support helps in a slump. Debt can limit this.
• Unemployment: works on cyclical unemployment, less on skills mismatch.
• Inflation: contractionary policy can restrain it, at the cost of output and jobs.

Must-know distinctions

• Direct tax versus indirect tax.
• Current versus capital expenditure.
• Transfer payments versus spending on goods and services.
• Keynesian AS (flat to steep) versus LRAS (vertical).
• Simple multiplier versus full multiplier.
• Discretionary policy (a new decision) versus automatic stabilisers (HL only).
• Short-run effect versus long-run effect in the monetarist/new classical view.

Command terms for this topic

The guide defines the terms as follows, in brief. Calculate: get a number and show the working. Explain: give reasons or causes. Evaluate: weigh strengths and limitations. Discuss: a balanced review with a supported conclusion. Show that: reach the stated result by clear steps. Draw: a labelled, accurate diagram.

The guide describes Paper 1 as an extended response paper (25 marks, 1 hour and 15 minutes). Paper 2 is a data response paper (40 marks, 1 hour and 45 minutes) with some quantitative questions. Paper 3, for HL only, is a policy paper (60 marks, 1 hour and 45 minutes).

Quick self-test

1. State two direct taxes and one indirect tax.
2. Orsland has revenue of 320 and expenditure of 345. What is the budget balance?
3. Is unemployment benefit current expenditure, capital expenditure or a transfer payment?
4. Which gap does contractionary policy target, and which way does AD shift?
5. (HL only) MPC = 0.6. Calculate the multiplier.
6. (HL only) MPS = 0.10, MPT = 0.10, MPM = 0.30. Calculate the multiplier.
7. (HL only) With a multiplier of 2, what is the rise in GDP from an export increase of 18?
8. (HL only) With a multiplier of 2, what injection closes a gap of 50?
9. (HL only) Government spending rises by 16, funded by borrowing, and investment falls by 6. The multiplier is 2. Find the change in GDP.
10. Name two constraints on fiscal policy that are available at SL.
11. In the monetarist/new classical view, what is the long-run effect of expansionary fiscal policy on output?
12. (HL only) Why do progressive taxes act as automatic stabilisers?

Answers

1. Income tax and corporate profits tax; sales tax.
2. 320 − 345 = −25, a deficit of 25.
3. A transfer payment.
4. An inflationary gap; AD shifts left.
5. 1 / (1 − 0.6) = 1 / 0.4 = 2.5.
6. 1 / (0.10 + 0.10 + 0.30) = 1 / 0.50 = 2.
7. 2 × 18 = 36.
8. 50 / 2 = 25.
9. Net injection 16 − 6 = 10; 10 × 2 = 20.
10. Any two of political pressure, time lags, sustainable debt.
11. None: output returns to potential and only the price level is higher.
12. Tax payments fall by more than proportionately when incomes fall, so disposable income falls less, and the reverse in a boom.

Where marks are usually lost

• Calculating the multiplier but not multiplying by the injection.
• Using 1 / (1 − MPC) when the question gives MPT and MPM.
• Treating a rise in the budget deficit as a rise in the national debt figure without saying the debt is the accumulated total.
• Shifting AD with no labelled equilibria or axes.
• Drawing a vertical LRAS for the Keynesian answer.
• Listing constraints without saying why each limits policy.
• Describing crowding out as always happening, with no link to borrowing and interest rates.
• Evaluation without a final judgment tied to the case in the question.

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.