IGCSE Economics 0455 – Government and the Macro‑economy: Fiscal Policy
Government and the Macro‑economy – Fiscal Policy
Objective
To understand the main areas of government spending, the reasons for spending in these areas and the likely effects on the economy.
1. Main Areas of Government Spending
Current (or recurrent) expenditure – day‑to‑day costs of running public services (e.g., salaries of civil servants, health‑care operating costs).
Capital expenditure – spending on long‑term assets such as roads, schools, hospitals and defence equipment.
Transfer payments – payments made without any direct goods or services being received (e.g., state pensions, unemployment benefits, welfare grants).
Interest payments – servicing the national debt.
2. Reasons for Government Spending
Provision of public goods – goods that are non‑excludable and non‑rivalrous (e.g., national defence, street lighting).
Redistribution of income – using taxes and transfers to reduce inequality.
Economic stabilisation – counter‑cyclical fiscal policy to smooth business‑cycle fluctuations.
Promotion of long‑term growth – investment in infrastructure, education and research.
Political objectives – fulfilling election promises, maintaining public support.
3. Effects of Government Spending
Government spending influences the macro‑economy through several channels:
Aggregate demand (AD) – an increase in spending raises AD directly. The total impact can be expressed by the fiscal multiplier:
\$k = \frac{1}{1 - MPC}\$
where \$MPC\$ is the marginal propensity to consume.
Inflation – if the economy is near full capacity, higher AD can generate demand‑pull inflation.
Public debt and interest rates – persistent deficits increase the stock of debt, potentially raising interest rates and crowding out private investment.
Income distribution – targeted transfer payments can reduce poverty and narrow the income gap.
Supply‑side effects – capital spending on infrastructure can improve productivity, shifting the long‑run aggregate supply (LRAS) outward.
4. Summary Table
Spending Area
Primary Reason(s)
Typical Economic Effect(s)
Current expenditure
Provide public services; maintain employment in the public sector
Increases AD; may raise wages in public‑sector jobs; limited long‑run growth impact
Initial rise in AD; later shift of LRAS outward; can lower future unemployment
Transfer payments
Redistribute income; support vulnerable groups; stabilise consumption
Raises disposable income of recipients → higher consumption; can be less inflationary if economy has idle capacity
Interest payments
Service existing debt; maintain creditworthiness
Diverts resources from other spending; may increase tax burden; can crowd out private investment if financed by borrowing
5. Suggested Diagram
Suggested diagram: The Keynesian fiscal multiplier – shift of the AD curve after an increase in government spending, showing the multiplier effect on equilibrium output.
6. Key Points to Remember
Fiscal policy works through changes in government spending and taxation.
The size of the multiplier depends on the marginal propensity to consume and the openness of the economy.
Short‑run effects (AD shift) differ from long‑run effects (LRAS shift) especially for capital spending.
While spending can stabilise the economy, excessive deficits may lead to high debt levels and future fiscal constraints.