📈 Expansionary
Cut taxes. Households keep more income and firms keep more profit, so they can spend and invest more.
Raise government spending. The government buys more, for example building schools or roads, which creates sales and jobs.
Fiscal Policy » Fiscal Policy
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 4.2.4, 4.2.5, 4.2.6
- What fiscal policy is
- How changes in taxes and government spending can be expansionary or contractionary
- How fiscal policy may help a government reach each of its macroeconomic aims
- How to write a short chain of cause and effect for each aim
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Unlock This CourseWhat is fiscal policy?
Governments collect taxes and spend money. The last three lessons looked at the budget, at taxes and at what taxes do to people and firms. Now we use those tools on purpose. A government can change the size of its taxes and its spending to push the whole economy in a chosen direction.
Key terms:
- Fiscal policy: the use of changes in taxes and government spending to influence the economy and help achieve the government's macroeconomic aims.
- Expansionary fiscal policy: a cut in taxes, a rise in government spending, or both, which increases total demand.
- Contractionary fiscal policy: a rise in taxes, a cut in government spending, or both, which reduces total demand.
Remember, total demand is all the spending in the economy: by households, firms, the government and foreign buyers of the country's exports. Fiscal policy works mainly by changing how much of it there is.
The two fiscal policy measures
There are only two levers to pull: taxes and government spending. Each can go up or down.
📉 Contractionary
Raise taxes. Households and firms have less to spend, so total demand falls.
Cut government spending. The government buys less, so firms that sell to it lose sales.
Worked example: Sarvonia
Sarvonia is a made-up country in a slump. Its government cuts income tax and spends $2 billion more on new railways. Households have more income to spend and railway firms hire more workers. Total demand rises. This is an expansionary fiscal policy. Later, prices begin to rise fast. The government raises taxes and cancels some projects. Total demand falls and price rises slow. This is a contractionary fiscal policy.
How fiscal policy helps each macroeconomic aim
A government may use fiscal policy to move towards each of its macroeconomic aims. Below is one short chain of cause and effect for each aim. The word may matters: these are the ways it can work, not guarantees. Judging how well each policy works comes in later lessons on each aim.
1. Economic growth
Cut taxes or raise government spending, so total demand rises. Firms sell more and produce more, so real GDP rises.
2. Full employment
Raise government spending on building schools or hospitals. Construction firms hire more workers. The workers spend their wages, so other firms hire too, and unemployment may fall.
3. Stable prices
Raise taxes or cut government spending, so total demand falls. Firms face weaker demand and are less able to raise prices, so inflation may slow.
4. Balance of payments stability
Raise income tax, so households have less income. They buy fewer goods, including fewer imports. Spending on imports falls, so a current account deficit (more spent on imports than earned from exports) may shrink.
5. Redistribution of income
Raise taxes on high incomes and spend more on welfare payments for low-income households. Rich households keep less and poor households gain, so the gap between them narrows.
6. Environmental sustainability
Put a tax on a polluting good such as fuel, or spend on public transport and clean energy. A taxed good costs more, so people use less of it. Pollution may fall.
🔄 Same lever, different aims
Cutting taxes may help growth and jobs. Raising taxes may help stable prices and the current account. The direction depends on which aim matters most.
⚠️ Aims can conflict
A measure that helps one aim can hurt another. Expansionary policy may boost jobs but also push up prices. This links to the lesson on conflicts between aims.
Common mistakes
- Saying a tax cut is contractionary. A tax cut is expansionary because spending rises.
- Writing "it reduces unemployment" with no chain. Always show the steps: spending, then demand, then output, then jobs.
- Mixing up fiscal policy with changes in interest rates. Fiscal policy is about taxes and government spending only.
Exam-style question
The government of Tolvaria, a made-up country, is worried that many people are out of work and that the economy is growing very slowly. It plans to cut income tax and to spend more on building new hospitals.
(a) Define fiscal policy. [2 marks]
(b) Explain two fiscal policy measures that the government of Tolvaria could use. [4 marks]
(c) Analyse how the government's plan may reduce unemployment. [6 marks]
Model answer
(a) Fiscal policy is the use of changes in taxes (1) and government spending (1) to influence the economy and achieve macroeconomic aims.
(b) One measure is cutting income tax (1). Households keep more of their pay, so they can spend more (1). A second measure is raising government spending on hospitals (1). This increases demand for building firms and workers (1).
(c) Spending on hospitals means construction firms get more orders (1). They need more workers, so they hire (1). Lower income tax means households have more to spend (1). Firms sell more goods and services, so total demand rises (1). Firms produce more and need extra workers (1). This increases the number of people in work, so unemployment may fall (1).
Exam tip
For an "Analyse" question, write each step as a link: "so", "which means", "therefore". Aim for one linked chain, not a list of separate facts.