IB DP Economics: Fiscal policy

This study guide follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. It covers sub-topic 3.6, Demand management – fiscal policy, in Unit 3 (Macroeconomics). Most of it is SL and HL. Three items are HL only and labelled “HL only” in the text: the Keynesian multiplier, crowding out (with its diagram), and automatic stabilisers.

All countries and numbers below are invented for illustration.

Related pages: revision notes for this unit, practice questions for this unit, the IB DP Economics hub, the printable checklist and the free 10-minute diagnostics. For the AD/AS models, see measuring and managing the economy.

What the guide asks you to know

Guide item	What you must be able to do	Level
Fiscal policy: revenue and expenditure	Name the sources of government revenue and the types of government spending	SL and HL
Goals of fiscal policy	Explain six goals and link each to a policy action	SL and HL
Expansionary and contractionary policy	Draw AD/AS diagrams for gaps under the Keynesian and the monetarist/new classical schools	SL and HL
Keynesian multiplier	Calculate the multiplier and the change in GDP from a change in an injection	HL only
Constraints and strengths	Evaluate fiscal policy	SL and HL
Crowding out, with a diagram	Explain and draw	HL only
Automatic stabilisers	Explain how progressive taxes and unemployment benefits cushion swings in activity	HL only

The guide marks the policy-and-gap and effectiveness material as evaluation topics (AO3), and the multiplier as application and calculation.

What fiscal policy is

Fiscal policy means changing government spending and taxes to steer aggregate demand and the wider economy. It sits within demand management, alongside monetary policy. Unlike monetary policy, it is set by the government itself.

Sources of revenue

The guide lists four sources.

• Direct taxes are paid by the person or firm that bears the burden, such as income tax and corporate profits tax.
• Indirect taxes are collected from a seller but passed on in prices, such as a sales tax or a tax on fuel.
• Sales of goods and services by state-owned enterprises, for example fares from a publicly owned railway.
• Sale of government assets, for example selling land or shares in a public company. This is usually a one-off receipt, so it is a weak basis for planning permanent spending.

Types of expenditure

• Current expenditure pays for the day-to-day running of government: wages, supplies, upkeep.
• Capital expenditure buys or builds assets that last, such as roads, schools and hospitals.
• Transfer payments pass money from taxpayers to recipients with no output produced in return, such as unemployment benefits and pensions.

Worked example: a budget table

Veldara is an illustrative economy. All figures are in billions of veld.

Revenue	Amount	Expenditure	Amount
Income tax	210	Current	310
Corporate profits tax	90	Capital	75
Sales tax	150	Transfer payments	105
State-owned enterprise sales	12
Sale of a government asset	8

• Total revenue = 210 + 90 + 150 + 12 + 8 = 470.
• Direct tax revenue = 210 + 90 = 300. Indirect tax revenue = 150.
• Total expenditure = 310 + 75 + 105 = 490.
• Budget balance = revenue − expenditure = 470 − 490 = −20. Veldara runs a deficit of 20 billion veld.

The 8 from the asset sale will not recur. Without it the shortfall is 28.

Goals of fiscal policy

The guide names six goals. For each, you should be able to say what the government does and how it works.

Goal	Typical fiscal action
Low and stable inflation	Cut spending or raise taxes when demand is too strong
Low unemployment	Raise spending or cut taxes when demand is weak
A stable environment for long-term growth	Predictable tax rules; capital spending on infrastructure
Reduced business cycle fluctuations	Counter-cyclical spending and tax changes
Equitable distribution of income	Progressive taxes and transfer payments
External balance	Policies that restrain spending on imports, or support exports, to move the current account towards balance

Goals can conflict: a tax cut that cuts unemployment may add to inflation.

Expansionary and contractionary policy

Expansionary fiscal policy raises government spending, cuts taxes, or both. It shifts AD to the right. It targets a deflationary (recessionary) gap, where actual output is below potential.

Contractionary fiscal policy cuts government spending, raises taxes, or both. It shifts AD to the left. It targets an inflationary gap, where actual output is above potential.

The guide asks for diagrams in two schools of thought, and the shape of AS is what separates them.

Keynesian view

The Keynesian AS curve is flat when there is a lot of spare capacity, slopes upwards as capacity tightens, and becomes vertical at full employment. The economy can settle at an equilibrium below full employment, and the guide notes that deflationary gaps can persist. Government action is therefore a way to speed up recovery.

To draw it: axes are price level (vertical) and real GDP (horizontal). Draw AS flat, then rising, then vertical at potential output Yf. Draw AD1 cutting the flat part at Y1, left of Yf. Shift AD to AD2.

Output rises towards Yf and the price level rises little, because AS is flat there. If AD shifted well beyond Yf, only prices would climb, which is why over-shooting is a risk.

Monetarist/new classical view

In this view LRAS is vertical at potential output, and the economy returns to it automatically. Expansionary fiscal policy shifts AD right, and in the short run output rises along SRAS. Wages and other costs then adjust, SRAS shifts left, and output returns to potential at a higher price level. The long-run result is inflation without extra output.

To draw it: draw a vertical LRAS at Yf and a rising SRAS1 crossing it. Draw AD1 cutting SRAS1 at Yf, then shift AD right to AD2. Output moves above Yf. Then shift SRAS left to SRAS2, and the new equilibrium is back at Yf with a higher price level.

On both diagrams, label the axes, every curve, the old and new equilibrium, and potential output.

Closing an inflationary gap

Veldara’s potential output is 820 billion veld and actual output is 860, a gap of 40. Contractionary policy shifts AD left, and output falls towards 820. The Keynesian argument is that waiting is slow and the government should act. The monetarist/new classical reply is that the economy corrects itself anyway.

The Keynesian multiplier (HL only)

An injection into the circular flow causes a larger rise in GDP, because one person’s spending becomes another’s income and part of it is spent again. The size depends on how much leaks out in each round.

The guide gives two forms.

• Simple form: multiplier = 1 / (1 − MPC), where MPC is the marginal propensity to consume.
• Fuller form: multiplier = 1 / (MPS + MPT + MPM), where MPS is the marginal propensity to save, MPT to tax and MPM to import.

The two agree when saving is the only leakage, because then 1 − MPC = MPS. When tax and imports also take a share of extra income, use the fuller form.

Change in GDP = multiplier × change in the injection. The injection may be investment, government spending or exports.

Worked example 1: the fuller form

Veldara has MPS = 0.08, MPT = 0.17 and MPM = 0.15. Government spending rises by 24 billion veld.

Leakages: 0.08 + 0.17 + 0.15 = 0.4
Multiplier: 1 divided by 0.4 = 2.5
GDP effect: 2.5 times 24 = 60

GDP rises by 60 billion veld. Working backwards, a recessionary gap of 60 needs an injection of 60 / 2.5 = 24.

Worked example 2: the simple form

A different closed economy has MPC = 0.8 and no taxes. Investment rises by 3.6.

Multiplier    = 1 / (1 - 0.8) = 1 / 0.2 = 5
Change in GDP = 5 x 3.6 = 18

A cut of 4 in government spending would lower GDP by 5 × 4 = 20.

Worked example 3: a cut

Veldara’s inflationary gap is 40 and the multiplier is 2.5. A cut in government spending of 40 / 2.5 = 16 closes the gap on this model.

The calculation assumes leakage rates stay fixed and treats the whole effect as real output. In practice some appears as higher prices, especially near full employment.

Effectiveness of fiscal policy

The guide lists constraints and strengths, then asks you to judge how well fiscal policy delivers growth, low unemployment and low, stable inflation. “Evaluate” asks you to weigh strengths against limitations.

Constraints

• Political pressure. Tax rises and spending cuts are unpopular, while tax cuts and spending rises are easy to sell. A needed contraction may be blocked.
• Time lags. Recognising a problem, passing a policy and spending the money all take time, so policy meant for a slump can arrive during a recovery.
• Sustainable debt. Deficits add to the national debt. Higher debt means higher interest payments, which use up future budgets and may deter lenders.
• Crowding out (HL only). Borrowing to finance a deficit competes with private borrowers for funds. Interest rates can rise, which cuts private investment.

Crowding out in numbers (HL only)

Veldara raises spending by 20 and borrows it all. Interest rates rise, and private investment falls by 8. The net injection is 20 − 8 = 12. With a multiplier of 2.5, GDP rises by 12 × 2.5 = 30, not the 20 × 2.5 = 50 that ignoring crowding out would suggest.

On an AD/AS diagram, show it in two steps. AD shifts right because of government spending, then shifts back part of the way as investment falls. The final AD sits to the right of where it began but to the left of the first shift. In the monetarist/new classical extreme the offset is complete.

Strengths

• Targeting. Spending can be aimed at a sector, a region or a group, such as a depressed area. A single interest rate cannot do this.
• Effective in a deep recession. When confidence is low and households and firms will not borrow even at low interest rates, government spending adds demand directly.

Automatic stabilisers (HL only)

The guide lists progressive taxes and unemployment benefits. They need no new decision, so they avoid the lags above. When incomes fall, tax payments fall faster than incomes and benefit payments rise, which softens the drop in disposable income. In a boom the effect reverses and restrains demand.

Example. Veldara’s income tax is 10% on the first 100 and 30% above that. A household’s income falls from 180 to 140.

Tax at 180 = 0.10 x 100 + 0.30 x 80 = 10 + 24 = 34
Tax at 140 = 0.10 x 100 + 0.30 x 40 = 10 + 12 = 22
Tax falls by 12
Disposable income: 146 falls to 118, a drop of 28

Income fell by 40, but disposable income fell by only 28, so 30% of the shock was absorbed. Under a flat 20% tax the tax would fall from 36 to 28, an 8 reduction, and disposable income would drop by 32.

Growth, unemployment and inflation

Fiscal policy can support growth through infrastructure and by lifting demand in a slump. It can reduce cyclical unemployment when output is below potential, but does little for unemployment caused by a skills mismatch. It can restrain inflation by cutting demand, at the cost of output and jobs.

Common errors

• Mixing up direct and indirect taxes, or treating a transfer payment as spending on goods and services.
• Using one diagram for both the Keynesian and the monetarist/new classical view.
• Stopping at the multiplier and forgetting to multiply by the injection.
• Describing crowding out as an effect that happens whenever the government spends, rather than when it borrows and interest rates rise.
• Listing strengths and limits with no judgment about which matters more.

Next steps

Condense this with the revision notes, then test yourself with the practice questions. See the IB DP Economics syllabus guide for where 3.6 fits.

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.