Fiscal policy measures: changes in government spending

Published by Patrick Mutisya · 14 days ago

Government and the MacroEconomy – Fiscal Policy: Changes in Government Spending

Government and the MacroEconomy – Fiscal Policy

Objective

Understand how changes in government spending are used as a fiscal policy tool to influence aggregate demand, output and employment.

Key Concepts

  • Government spending (G): Expenditure by central and local authorities on goods, services and public investment.

  • Aggregate demand (AD): \$AD = C + I + G + (X - M)\$.

  • Expansionary fiscal policy: Increase in G (or decrease in taxes) to boost AD.

  • Contractionary fiscal policy: Decrease in G (or increase in taxes) to reduce AD.

How Changes in Government Spending Affect the Economy

  1. Direct impact on aggregate demand through the \$G\$ component.

  2. Multiplier effect: an initial change in G leads to a larger total change in national income.

  3. Potential crowding‑out or crowding‑in of private investment.

Fiscal Multiplier

The fiscal multiplier (k) shows the total change in output (\$\Delta Y\$) resulting from a change in government spending (\$\Delta G\$):

\$\$

k = \frac{\Delta Y}{\Delta G}

\$\$

In a simple closed economy with no taxes and a marginal propensity to consume (MPC) of \$c\$, the multiplier is:

\$\$

k = \frac{1}{1 - c}

\$\$

If taxes (t) are present, the multiplier becomes:

\$\$

k = \frac{1}{1 - c(1-t)}

\$\$

Factors Influencing the Size of the Multiplier

  • Marginal propensity to consume (MPC) – higher MPC → larger multiplier.

  • Tax structure – higher tax rates reduce the multiplier.

  • Open economy – imports leak out of the spending stream, lowering the multiplier.

  • State of the economy – near full‑capacity output may limit the multiplier due to price pressures.

Advantages of Using Government Spending

  • Direct and immediate impact on AD.

  • Can target specific sectors (e.g., infrastructure, health, education).

  • Creates employment directly through public‑sector jobs.

Disadvantages / Limitations

  • Time lags: planning, approval, and implementation can be lengthy.

  • Risk of crowding‑out if increased borrowing raises interest rates.

  • Potential for inefficient allocation of resources.

  • Higher public debt if spending is financed by borrowing.

Illustrative Example

ScenarioInitial Government Spending (\$G\$)Change in \$G\$MPC (c)Tax Rate (t)Multiplier (k)Estimated Change in GDP (\$\Delta Y\$)
Expansionary$200 bn+$20 bn0.80.20\$\frac{1}{1-0.8(1-0.20)} = 3.33\$\$20 bn × 3.33 ≈ \$66.6 bn
Contractionary$200 bn−$15 bn0.750.25\$\frac{1}{1-0.75(1-0.25)} = 2.67\$−\$15 bn × 2.67 ≈ −\$40.0 bn

Policy Decision Flowchart (Suggested diagram)

Suggested diagram: Flowchart showing the decision‑making process for using changes in government spending as a fiscal policy tool, including assessment of economic conditions, selection of expansionary or contractionary measures, implementation steps, and expected outcomes.

Exam Tips for IGCSE 0455

  • Remember the formula for the fiscal multiplier and be able to adapt it for different assumptions (taxes, imports).

  • When asked to evaluate, discuss both the short‑run impact on AD and the long‑run considerations such as debt sustainability.

  • Use real‑world examples (e.g., post‑2008 stimulus, UK infrastructure programmes) to illustrate points.

  • Structure answers: define, explain mechanism, give diagram/flowchart, evaluate advantages and disadvantages.

Practice Question

“The government decides to increase spending on road construction by $10 bn. Assuming an MPC of 0.75 and no change in taxes, calculate the expected change in national income and discuss two possible drawbacks of this policy.”

Answer Outline

  1. Calculate multiplier: \$k = \frac{1}{1-0.75}=4\$.

  2. Change in GDP: \$\Delta Y = 4 \times 10 bn = \$40 bn.

  3. Drawbacks:

    • Potential crowding‑out if financing requires borrowing that raises interest rates.

    • Risk of inflationary pressure if the economy is already near full capacity.