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YOUR NOTES
IB Economics HL 

3.6 Demand Management: Fiscal Policy

CONTENTS
3.6.1 An Overview of Fiscal Policy
3.6.2 The Keynesian Multiplier
3.6.3 An Evaluation of Fiscal Policy

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3.6.1 An Overview of Fiscal Policy YOUR NOTES


An Introduction to Fiscal Policy
Fiscal Policy involves the use of government spending and taxation (revenue) to influence
aggregate demand in the economy

Fiscal policy can be expansionary in order to generate further economic growth

Expansionary policies include reducing taxes or increasing government spending

Fiscal policy can be contractionary in order to slow down economic growth or reduce
inflation
Contractionary policies include increasing taxes or decreasing government spending

Fiscal Policy is usually presented annually by the Government through the Government
Budget
A balanced budget means that government revenue = government expenditure
A budget deficit means that government revenue < government expenditure
A budget surplus means that government revenue > government expenditure

A budget deficit has to be financed through public sector borrowing

This borrowing gets added to the public debt

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Sources of Government Revenue YOUR NOTES

The main sources of government revenue include taxation, the sale of goods/services by 
government owned firms, and the sale of government owned assets (privatisation)

1. Taxation
Direct taxes are taxes imposed on income and profits
They are paid directly to the government by the individual or firm
E.g. Income tax, corporation tax, capital gains tax, national insurance
contributions, inheritance tax

Indirect taxes are imposed on spending

The supplier is responsible for sending the payment to the government
Depending on the PED and PES producers are able to pass on a proportion of the
indirect tax to the consumer
The less a consumer spends the less indirect tax they pay
E.g Value Added Tax (20% VAT rate in the UK in 2022), taxes on demerit goods,
excise duties on fuel etc.

2. Sale of goods/services
Government owned firms sometimes charge for the goods/services that they provide
E.g. Charges on public transport and fees paid to access some medical services

3. The sale of government owned assets

Privatisation can generate significant government revenue during the year in which the
government sells the asset
Most assets can only be sold once e.g. national airlines or railways
Some assets, such as the right for mobile phone operators to use the airwaves, can
be sold every few years (the airway license is for a defined period of time)

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Government Expenditure YOUR NOTES

Government expenditure represents a significant portion of the aggregate demand in 
many economies. The expenditure can be broken down into three categories

1. Current expenditures: These include the daily payments required to run the government
and public sector. E.g. The wages and salaries of public employees such as teachers,
police, members of parliament, military personnel, judges, dentists etc. It also includes
payments for goods/services such as medicines for government hospitals

2. Capital expenditures: These are investments in infrastructure and capital equipment. E.g.
High speed rail projects; new hospitals and schools; new aircraft carriers

3. Transfer payments: These are payments made by the government for which no
goods/services are exchanged. E.g. Unemployment benefits, disability payments,
subsidies to producers and consumers etc. This type of government spending does not
contribute to aggregate demand as income is only transferred from one group of people
to another

The Goals of Fiscal Policy

Fiscal policy is used to help the government achieve their macroeconomic objectives
Specifically, the use of fiscal policy aims to
Maintain a low and stable rate of inflation
Maintain low unemployment
Reduce the business cycle fluctuations
Create a stable economic environment for long-term economic growth
Redistribute income so as to ensure more equity
Control the level of exports and imports (net external balance)

When a policy decision is made, it creates a ripple effect through the economy impacting
the macroeconomic objectives of the government
Changes to fiscal policy can influence several of the components of AD
A change to any component of AD helps to achieve at least one of the goals of fiscal
policy

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Expansionary & Contractionary Fiscal Policy YOUR NOTES

1. Expansionary Fiscal Policy 
Expansionary fiscal policies include reducing taxes or increasing government spending
with the aim of increasing AD

AD= household consumption (C) + firms investment (I) + government spending (G) +
exports (X) - imports (M)
AD = C + I + G + (X - M)

Expansionary fiscal policy aims to shift aggregate demand (AD) to the right

Classical diagram illustrating expansionary fiscal policy which increase real GDP (Y1 →Y2)
and average price levels (AP1 →AP2)

Diagram Analysis
The economy is initially in macroeconomic equilibrium AP1Y1 - there is a recessionary gap
The Government is wanting to boost economic growth and lowers the rate of income and
corporation taxes
Lower taxes cause investment and consumption to increase which are components of AD
Aggregate demand increases from AD→ AD1
The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a
greater level of national output
Examples of the Impact of Expansionary Fiscal Policy

Example 1: The Government decreases corporation tax

Effect on the economy Firms net profits increase → investment by firms increases → AD
increases

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YOUR NOTES
Impact on Economic growth increases
macroeconomic aims Inflation rises 
Unemployment may decrease as output is rising which
requires more workers
Net external demand - unsure - exports may rise due to new
investments in the economy, but imports may rise due to
higher income generated by the investment

Example 2: The Government increases unemployment benefits

Effect on the economy Household income increases → consumption increases → AD

increases

Impact on Economic growth increases

macroeconomic aims Inflation rises
Unemployment may decrease as output is rising which
requires more workers (although increased unemployment
benefits may discourage some people from entering the
labour market)
Net external demand is unlikely to change as this policy helps
the poorest and imports are unlikely to increase
Redistribution of income has increased and there is more
equity in society

2. Contractionary Fiscal Policy

Contractionary fiscal policies include increasing taxes or decreasing government spending
with the aim of decreasing AD

AD= household consumption (C) + firms investment (I) + government spending (G) +
exports (X) - imports (M)
AD = C + I + G + (X - M)

Changes to fiscal policy can influence government spending or consumption or

investment
Changing taxation can influence household consumption and the investment by firms

Contractionary fiscal policies aims to shift aggregate demand (AD) to the left

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YOUR NOTES


Keynesian diagram illustrating how a contractionary fiscal policy aims to decrease real GDP
(YFE →Y1) and average price levels (AP1 →AP2)

Diagram Analysis
The economy is initially in macroeconomic equilibrium AP1YFE - an inflationary output gap is
developing
The economy is booming and the Government is wanting to lower inflation towards its
target of 2%
The Government increases the rate of income tax
Higher tax rates cause households to have less discretionary income causing
consumption to decrease
Aggregate demand decreases from AD1→ AD2
The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller
level of national output

Examples of the Impact of Contractionary Fiscal Policy

Example 1: The Government increases the rate of income tax

Effect on the economy Households pay more tax → discretionary income reduces →
consumption reduces → AD reduces

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YOUR NOTES
Impact on Economic growth slows down
macroeconomic aims Inflation eases 
Unemployment may increase as output is falling and fewer
workers are required
Net external demand Improves (with less income, imports
may fall)

Example 2: The Government freezes/reduces public sector workers pay

Effect on the economy Wages stagnate or reduce → Consumer confidence falls →

consumption decreases → AD decreases

Impact on Economic growth slows down

macroeconomic aims Inflation eases
Unemployment may increase as output is falling
Net external demand improves (with less income, imports may
fall)

Example 3: The Government cuts Government Spending in their Budget

Effect on the economy Less demand for goods/services → less income for firms → output
and profits decrease → AD decreases

Impact on Economic growth slows down

macroeconomic aims Inflation eases
Unemployment may increase as output is falling
Net external demand may Improve (with less income, imports
may fall)
Less corporation tax available for redistribution

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3.6.2 The Keynesian Multiplier YOUR NOTES


An Introduction to the Keynesian Multiplier
The multiplier is the ratio of change in real income to the injection that created the
change
E.g. If the Brazilian government injected an additional 5bn Brazilian real (BZL) into the
economy through government spending and it resulted in an increase in real income of
15bn BZL, the value of the multiplier would be 3

The multiplier process is based on the idea that one individual's spending is another
individual's income
An increase in consumption immediately increases AD
Store owners who have benefitted from the extra consumption now have extra
income
They spend some of that income on goods/services
Their expenditure on goods/services is now income for the next tier of individuals

Due to the successive rounds of spending, the final increase in national income is
much larger than the initial injection
The size of the multiplier is entirely dependent on the size of leakages that occur during
the process
The higher the leakages the smaller the multiplier

The initial injection shifts AD to the right

The result of the multiplier process is that there is then a secondary movement of AD
to the right which (if the multiplier were 2) may be double the initial movement

The multiplier can also work in reverse when injections are reduced (downward multiplier
effect)

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The Effects of Marginal Propensities on the Multiplier YOUR NOTES

The 'marginal propensities' refer to the proportion of the next $ earned that a consumer 
saves, consumes, is taxed, or purchases imports with
Marginal propensities are calculated for economies and provide insights into how each
additional $ of income is allocated
Sweden has a higher tendency to save than the USA
Their marginal propensity to save is higher
The USA, therefore, has a greater multiplier on any injections into the Circular Flow

An Explanation of the Marginal Propensities

Marginal Propensity Explanation Formula

Marginal Propensity to The proportion of additional income MPC =

∆C
Consume (MPC) that is spent on consumption (C) ∆Y

Marginal Propensity to The proportion of additional income MPS =

∆S
Save (MPS) that is saved (S) ∆Y

Marginal Propensity to Tax The proportion of additional income MPT =

∆T
(MPT) that is paid in tax (T) ∆Y

Marginal Propensity to The proportion of additional income MPM =

∆M
Import (MPM) that is spent on imports (M ∆Y

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Calculating the Multiplier YOUR NOTES

The value of the multiplier can be calculated one of two ways 
By focusing on the marginal propensity to consume (MPC)
Or, by focusing on the withdrawals that occur on each additional $ of income (MPS +
MPT + MPM)

1. Focussing on the MPC

1
Multiplier =
(1 − MPC)

2. Focusing on the Withdrawals

1 1
Multiplier = =
MPW (MPM + MPS + MPT)

 Worked Example
An economy has the marginal propensity to save of 0.15, marginal propensity to tax
of 0.20 and a marginal propensity to import of 0.15.
a) Calculate the size of the multiplier.
b) If the Government increases their infrastructure spending by £60m, calculate
the total increase in GDP, assuming all other things remain equal.

Step 1: Insert the values into the withdrawal formula

1
Multiplier =
(MPM + MPS + MPT)

1 1
= =
(0. 15 + 0. 15 + 0. 20) 0.5

= 2

Step 2: Multiply the injection by the multiplier

Impact on GDP = Injection x multiplier
= £60m x 2
= £120m

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YOUR NOTES
 Worked Example

Calculate the amount of government spending required to restore an economy's
macroeconomic equilibrium if the economy faces a $22bn recessionary gap and its
MPC is 0.6 [2]
Step 1: Calculate the multiplier
1
Multiplier =
(1 − MPC)

1
Multiplier =
(1 −0.6)

Multiplier = 2.5 ⎡⎢⎣ 1 mark ⎤⎥⎦

Step 2: Calculate the value of government spending required

$ 22 bn
Government spending required =
2. 5

Government spending required = $ 8. 80 bn ⎢⎣ 1 mark ⎥⎦

⎡ ⎤

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Significance of the Multiplier in Shifting Aggregate Demand (AD) YOUR NOTES

The greater the withdrawals, the smaller the value of the multiplier - and vice versa 
The greater the MPC, the higher the value of the multiplier - and vice versa

Any change in one of the factors that impacts on disposable income, will change the
multiplier
If taxes increase the value of the multiplier reduces
If interest rates increase, savings increase and consumption decreases and the
multiplier reduces
If exchange rates appreciate the level of imports will increase and the multiplier
decreases
If confidence in the economy increases consumption increases and the multiplier
increases

It is extremely useful for the Government to know the value of the multiplier
They can use it to judge the likely economic growth caused by increased spending

There is a time lag as it takes time for the successive rounds of income to work through the
economy

 Exam Tip
The final bullet point above mentions time lags. This is an excellent point to include in
any evaluation on the effectiveness of the multiplier. It may take up to 18 months for
the full multiplier effect to be seen & any change to consumer confidence during this
period will impact the final outcome.

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3.6.3 An Evaluation of Fiscal Policy YOUR NOTES


Strengths of Fiscal Policy
Spending can be targeted at specific industries
It can be highly effective in restoring confidence in an economy during a deep recession
Redistributes income through taxation
Reduces negative externalities through taxation
Increased consumption of merit/public goods
Short term government spending can lead to an increase in the aggregate supply of an
economy
E.g. Building a new airport immediately increases government spending and AD, but
when it is built, the potential output will have increased (Production Possibility Curve
has shifted outward)

Automatic Stabilisers as a Strength of Fiscal Policy

Automatic stabilisers are automatic fiscal changes that occur as the economy moves
through stages of the business/trade cycle

The impact of automatic stabilisers on an economy during a boom and recession

1. Effect in a recession
In a recession, there will (automatically) be lower tax revenue due to the nature of
progressive taxation - as incomes fall households are taxed less
In a recession, as unemployment rises, the government will pay higher unemployment
benefits / transfer payments which households will then be used for consumption

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Both of the above will result in real GDP being higher than it would otherwise have YOUR NOTES
been 

2. Effect in a boom
In a boom, there will (automatically) be higher tax revenue due to the nature of
progressive taxation - as incomes rise households are taxed more
In a boom, as unemployment falls the government will pay less unemployment
benefits / transfer payments which households which then does not get generate
increased consumption
Both of the above will result in real GDP being lower than it would otherwise have been
This is effectively an automatic disinflationary effect

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Weaknesses of Fiscal policy YOUR NOTES

Political pressures: Policies can fluctuate significantly when new governments are 
elected
Long term infrastructure projects may lack follow-through

Unsustainable debt: Increased government spending can create budget deficits which are
added to the national debt
Repaying this debt may lead to austerity on future generations

Conflicts between objectives

E.g. Cutting taxes to increase economic growth may cause inflation

Time lags: It is difficult to predict exactly when the desired effect on the economy will
occur. Fiscal policy also takes a longer time to plan and implement than monetary policy
Government budgets are usually presented once a year whereas monetary policy
adjustments can take place 4-8 times per year

Crowding Out as a Weakness of Fiscal Policy

Crowding out refers to a phenomenon where expansionary fiscal policy, particularly
government spending, can result in a reduction of private sector spending or investment

Government borrowing results in competition with others in the economy who want to
borrow the limited amount of savings available
This competition causes the real interest rate to rise and private investment
decreases (is crowded out)

The diagram on the left shows how government borrowing increases interest rates, resulting
in a fall in AD in the diagram on the right as private firms are crowded out of the market

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YOUR NOTES
Diagram Analysis 

Increased government borrowing causes the demand for money in the loanable funds
market to increase from DM1 →DM2
This extra demand raises interest rates from R1→R2
The government increases their spending using the borrowed funds and aggregate
demand in the economy increases from AD1→AD2
The increase in AD is greater than the actual value of the injection due to the
Keynesian multiplier

Private firms are put off from borrowing loanable funds due to the increased rate of
interest and investment falls
As investment falls, aggregate demand decreases, shifting back to AD3

Private firms have been crowded out of the market by the governments actions

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