Fiscal policy — common mistakes

In your analysis, clearly distinguish between government spending on goods and services (G), which is a direct component of AD, and transfer payments. Transfer payments are not part of G; they increase households' disposable income, thereby influencing consumption (C).

When evaluating fiscal policy, always consider the potential size of the multiplier. A large multiplier means a small change in government spending can have a significant impact on real GDP, but it also increases the risk of 'overshooting' the target and causing high inflation.

When comparing G and T changes, remember $1 of G has a larger multiplier effect than $1 of tax cut because part of a tax cut is saved. State this in evaluation questions.

Not necessarily. Increasing government spending (G) is a direct injection into the circular flow and has a full multiplier effect. A tax cut's effectiveness depends on what households do with the extra disposable income. If they save a large portion (a high MPS), the impact on aggregate demand will be smaller than a direct increase in G. However, tax cuts can also boost incentives to work and invest, which affects aggregate supply. The 'better' option depends on the specific economic context and policy goals.

It depends on the state of the economy. If the economy is in a deep recession with significant spare capacity (i.e., operating on the horizontal or Keynesian part of the AS curve), an increase in AD is likely to increase real GDP with little to no effect on the price level. However, if the economy is already operating near full capacity (on the vertical part of the AS curve), the same increase in AD will be purely inflationary, with no increase in real GDP.

While a government can run deficits for many years, it is not sustainable indefinitely without consequences. Persistent deficits add to the national debt. A rising national debt as a percentage of GDP can lead to higher interest payments, which creates an opportunity cost. It may also lead to a loss of confidence from investors, higher borrowing costs in the future, and potential 'crowding out' of private investment. The sustainability depends on the size of the deficit relative to GDP, the rate of economic growth, and the level of interest rates.