IGCSE Economics 0455 – Government and the Macro‑economy: Fiscal Policy
Government and the Macro‑economy – Fiscal Policy
1. What is Fiscal Policy?
Fiscal policy is the use of government spending and taxation to influence the level of aggregate demand (AD) in an economy. It is a key tool for achieving the macro‑economic aims set out in the national policy framework.
2. The Macro‑economic Aims
Economic growth – increase in real GDP.
Low unemployment – moving the economy towards full employment.
Price stability – keeping inflation low and stable.
External balance – a sustainable current‑account balance.
Equitable distribution of income – reducing poverty and inequality.
3. Fiscal‑policy Instruments
Instrument
Expansionary Effect
Contractionary Effect
Government spending (G)
Increase G → AD ↑ → Real GDP ↑
Decrease G → AD ↓ → Real GDP ↓
Direct taxes (e.g., income tax)
Decrease taxes → Disposable income ↑ → Consumption ↑ → AD ↑
Increase taxes → Disposable income ↓ → Consumption ↓ → AD ↓
Indirect taxes (e.g., VAT)
Decrease taxes → Prices of goods fall → Real consumption ↑ → AD ↑
Increase taxes → Prices rise → Real consumption ↓ → AD ↓
4. Types of Fiscal Policy
Expansionary fiscal policy: Used to boost AD when the economy is below potential output (recession). It involves increasing G or cutting taxes.
Contractionary fiscal policy: Used to restrain AD when the economy is overheating (high inflation). It involves decreasing G or raising taxes.
5. The Fiscal Multiplier
The fiscal multiplier shows how a change in autonomous spending (ΔG or ΔT) leads to a larger change in equilibrium output.
These are built‑in fiscal mechanisms that automatically counteract fluctuations in AD without explicit government action.
Progressive income tax – tax revenue rises as incomes rise, reducing disposable income.
Unemployment benefits – increase government outlays when unemployment rises, supporting consumption.
7. Discretionary Fiscal Measures
These are deliberate changes in spending or taxation decided by the government, such as a stimulus package or a tax cut announced in a budget.
8. Fiscal‑policy Lags
: Time taken to recognise that the economy needs intervention.
Decision lag: Time taken to decide on the appropriate policy response.
Implementation lag: Time taken for the policy to be put into effect (e.g., passing legislation, allocating funds).
Effect lag: Time taken for the policy to affect AD and the macro‑economy.
9. Interaction with the Budget
Budget deficit: When G > T. Deficit financing may increase public debt.
Budget surplus: When T > G. Used to reduce debt or cool an overheating economy.
Public debt: Accumulated deficits. High debt can lead to higher interest rates (crowding‑out) and limit future fiscal space.
10. Evaluation of Fiscal Policy
Advantages
Direct impact on AD through government spending.
Automatic stabilisers provide continuous counter‑cyclical support.
Can be targeted to specific sectors (e.g., infrastructure) to improve long‑term growth potential.
Disadvantages
Time lags may cause policy to be pro‑ or anti‑cyclical.
Risk of crowding‑out if increased borrowing raises interest rates.
High deficits can increase public debt, leading to future tax burdens.
Political pressures may lead to inappropriate timing or magnitude of measures.
Effectiveness depends on
Size of the multiplier (higher when economy has idle resources).
State of the economy (recession vs. inflationary gap).
Coordination with monetary policy.
Credibility of government and expectations of households and firms.
Suggested diagram: AD‑AS model showing the right‑ward shift of AD after an expansionary fiscal policy and the left‑ward shift after a contractionary fiscal policy.
Suggested diagram: The fiscal multiplier process – initial change in G or T, induced change in consumption, and final change in equilibrium output.