Revise Fiscal policy for Cambridge 9708 (5.2)

Fiscal policy is a primary demand-side policy tool used by governments to manage the economy. It involves the deliberate manipulation of two key instruments: government spending (G) and taxation (T). Government spending can be categorised into current spending (e.g., public sector wages), capital spending (e.g., infrastructure projects), and transfer payments (e.g., unemployment benefits). Taxation includes direct taxes levied on income and wealth (e.g., income tax) and indirect taxes on expenditure (e.g., VAT). By adjusting these levers, the government aims to influence the level of aggregate demand (AD), thereby steering the economy towards its macroeconomic objectives of stable prices, full employment, and sustainable economic growth. The balance between G and T determines the government's budget position.

Expansionary fiscal policy is implemented to stimulate economic activity, typically during a recession or a period of high unemployment. The government can achieve this by increasing its spending (↑G) on projects like infrastructure, or by cutting taxes (↓T) to increase the disposable income of households and firms. Both actions serve to increase aggregate demand, shifting the AD curve to the right. In the AD/AS model, this leads to a higher equilibrium level of real GDP, helping to close a negative output gap and reduce unemployment. However, this policy also risks causing demand-pull inflation if the economy is close to full capacity. It will almost certainly lead to a larger budget deficit or a smaller surplus.

Contractionary fiscal policy is used to dampen aggregate demand, primarily to combat demand-pull inflation. To do this, the government can decrease its spending (↓G) or increase taxes (↑T). A reduction in government spending directly lowers AD. An increase in taxes, such as income tax or corporation tax, reduces the disposable income of households and the post-tax profits of firms, leading to lower consumption (C) and investment (I). In the AD/AS framework, this shifts the AD curve to the left, which helps to reduce pressure on the price level. While effective at controlling inflation, this policy can slow economic growth and potentially lead to higher unemployment. It will tend to reduce a budget deficit or create a budget surplus.

The multiplier effect is a crucial concept in fiscal policy, as it amplifies the impact of an initial change in spending. An injection of new government spending (G) into the circular flow of income leads to a more than proportional final increase in national income. The size of the multiplier (k) is determined by the marginal propensity to withdraw (MPW), which is the sum of the marginal propensities to save (MPS), tax (MPT), and import (MPM). The formula is k = 1/MPW. A smaller MPW (or a larger Marginal Propensity to Consume, MPC) means a larger multiplier. This means a relatively small fiscal stimulus can have a large impact on real GDP, but it also magnifies the impact of fiscal consolidation.

The effectiveness of fiscal policy is subject to several significant limitations. Time lags are a major issue; there are delays in recognising the economic problem, deciding on the appropriate policy, and implementing it. By the time the policy takes effect, the economic conditions may have changed. Another key limitation is 'crowding out', where increased government borrowing to fund a deficit drives up interest rates, which in turn reduces private investment and consumption, offsetting the initial stimulus. Furthermore, political considerations can lead to policies designed for electoral gain rather than economic stability. The impact also depends heavily on the initial state of the economy and the uncertain size of the multiplier, making precise calibration of policy extremely difficult.

Budget balance = T − G

Government spending multiplier: $k_g = \frac{1}{1 - MPC}$

Tax multiplier: $k_t = \frac{-MPC}{1 - MPC}$

Balanced budget multiplier ≈ 1 (equal ΔG and ΔT)