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2281 · 4.3

Fiscal policy — practice questions

Practice and worked examples for 2281 Fiscal policy. Short previews only — attempt the full question in MarkScheme against the official scheme.

Worked example 1

MPC = 0.75. The government increases spending on hospitals by $20 billion, financed by borrowing.

(a) Calculate the government spending multiplier. (b) Calculate the total change in national income. (c) If crowding out reduces private investment by $5 billion, estimate the net effect on AD.

Show solution outline

(a) Multiplier k = 1 ÷ (1 − 0.75) = 1 ÷ 0.25 = 4

(b) Total ΔY ΔY = k × ΔG = 4 × 20bn=∗∗20bn = **80 billion**

(c) Net effect with crowding out Gross fiscal boost = +80bntoY80bn to Y Crowding out: I falls by $5bn → secondary reduction ≈ 4 × $5bn = **20bn∗∗20bn** Net ΔY ≈ 80bn−80bn − 20bn = $60 billion (crowding out reduces but does not eliminate the stimulus)

Worked example 2

An economy is at full capacity (Y = Yf) with inflation at 7%. The government proposes a $15bn tax cut.

(a) Is this expansionary or contractionary? (b) Show the AD–AS effect. (c) Evaluate the policy.

Show solution outline

(a) Policy type Tax cut → higher disposable income → C rises → expansionary fiscal policy.

(b) AD–AS effect AD shifts right. At Yf, SRAS is steep — mainly P rises (demand-pull inflation) with little sustainable Y gain.

(c) Evaluation Against: inflation already 7%; stimulus worsens price stability; at Yf, output gains are limited. For: if inflation is cost-push not demand-pull, tax cut may help households — but does not fix supply side. Verdict: contractionary fiscal policy (↑T or ↓G) more appropriate to reduce inflation.

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