Fiscal policy measures: changes in government spending

Government and the macroeconomy – Fiscal policy

What is Fiscal Policy?

Fiscal policy is the government’s use of taxes and spending to influence the economy. Think of it like a family budget: if the family spends more on groceries, the grocery store gets more money, and the whole neighbourhood feels a bit richer.

In the economy, the government can:

  • Increase spending (e.g., build new roads, schools, hospitals)

  • Decrease spending (e.g., cut subsidies, stop building projects)

  • Change taxes (not the focus of this note, but part of fiscal policy)

Fiscal Policy Measures: Changes in Government Spending

When the government changes its spending, it can either stimulate (increase) or slow down (decrease) economic activity.

🔹 Expansionary fiscal policy – the government spends more.

🔹 Contractionary fiscal policy – the government spends less.

These changes affect the aggregate demand curve, shifting it right or left.

The Fiscal Multiplier

The impact of a change in government spending is magnified by the fiscal multiplier.

Formula:

ΔY = \dfrac{1}{1-MPC} \times ΔG

Where:

  • ΔY = change in real GDP

  • ΔG = change in government spending

  • MPC = marginal propensity to consume (how much people spend out of each extra dollar)

Example: If MPC = 0.8 and the government spends an extra £100 million, the multiplier is 1/(1-0.8) = 5. So, real GDP could rise by £500 million.

Illustrative Example: Building a New School

Imagine the government decides to build a new school costing £200 million.

  1. The construction company gets paid, boosting its income.

  2. Workers receive wages, increasing their spending.

  3. More spending means higher demand for goods and services.

  4. Businesses hire more staff, further raising income and spending.

All of this creates a ripple effect, amplifying the initial £200 million into a larger boost to the economy.

When to Use Expansionary vs. Contractionary Policy

SituationPolicy Action
High unemployment, low growthIncrease spending (e.g., infrastructure projects)
High inflation, overheating economyDecrease spending (e.g., cut subsidies)

Exam Tips 📚

  • Define fiscal policy and its tools (taxes, spending).

  • Explain how changes in spending shift the aggregate demand curve.

  • Use the fiscal multiplier to show the magnitude of the effect.

  • Give real-world examples (e.g., stimulus packages, austerity measures).

  • Remember to label graphs clearly if you draw the AD curve.