Demand-Side Policies Fiscal

Demand-side policies
Fiscal
Introduction
Involves the use of government spending and taxation to fulfil macroeconomic
objectives by influencing AD
1. Expansionary fiscal policy

2. Contractionary fiscal policy
Fiscal policy tools
● Government spending on physical capital goods
● Government spending on human capital formation
● Provision of incentives for firms to invest
The 6 main objectives of fiscal policy
1. Low unemployment
2. Promoting a stable economic environment for long-term growth
3. Low and stable inflation
4. Reducing business cycle fluctuations
5. Achieving an equitable distribution of income
6. Trade balance
Taxation
Direct taxes are imposed on income (rent, wages, interest, profit)
● Income tax
● Corporation tax
● Capital gains tax
Indirect taxes are imposed on expenditure
● Sales tax
● Excise taxes
Revenues and expenditure
Expenditures refer to money spent by governments, either through government
spending (G) or transfer payments.
Transfer payments are payments made by the government without goods or

services being received in return, such as welfare payments and donations
Revenues and expenditure
Current expenditures (short-term)
● Wages for public sector employees
● Supplies for public sector businesses
● Interest payments for national debt
● The provision of subsidies and grants
Capital expenditures (long-term)

● Infrastructure
Balanced, surplus & deficit

Expansionary fiscal policy
● Increasing government expenditure
● Decreasing direct and indirect taxation
Contractionary fiscal policies
● Decreasing government expenditure
● Increasing direct and indirect taxation
The Keynesian multiplier (HL)
When presented with an additional unit of income, households can:
1. Be taxed by the government

2. Save
3. Consume goods & services
4. Import goods & services
Terminology
Marginal propensity to tax (MPT)
Marginal propensity to save (MPS)
Marginal propensity to consume (MPC)
Marginal propensity to import (MPM)
MPT + MPS + MPC + MPM = 1

The Keynesian multiplier
Refers to the idea that the spending of one party becomes the income of another
party, which then becomes further spending, with the cycle repeating infinitely.
As such, an injection in the circular flow produces a chain reaction of further

expenditure, with the effect of increasing AD and real GDP to a value greater than
the initial expenditure.
Multiplier formula
1 / (1 - MPC) or 1 / (MPM + MPS + MPT)
Evaluation of fiscal policy
The strengths include:
● Ability to target specific economic sectors
● Stimulates recovery from a deep recession
Limitations:
● Political pressures
● Time lags
● Sustainable debt
● Crowding out (HL)
Crowding out
When governments run a budget deficit, it needs to borrow funds.
Crowding occurs when increased government borrowing causes interest rates to

rise owing to the higher demand for loanable funds.
Overall this causes a reduction in private sector investment expenditure due to the
higher costs of borrowing.
Automatic stabilizers (HL)
Factors that stabilize the economy without government intervention by dampening
the short-term fluctuations of the business cycle
Automatic stabilizers
Progressive income taxes as automatic stabilizers
During an expansion:
1. Incomes rise as national output increases

2. As income rise, households will be taxed a higher proportion of their income
3. This prevents the economy from overheating
During a recession:
1. Incomes fall with national output

2. As incomes fall, households will be taxed a lesser proportion of their income
3. This reduces pressure on falling AD and counteracts the economic contraction
Automatic stabilizers
Unemployment benefits as automatic stabilizers
During expansions
● Some workers may be inclined to stay unemployed to claim unemployment benefits
● As a result, national output does not rise too quickly
During contractions
● The distribution of unemployment benefits rise as they are offered to more
unemployed workers
● Household consumption will be somewhat maintained, lessening the downward
pressure on AD
Key terms
Fiscal policy - refers to the use of government spending and tax policies to influence economic conditions, including demand for goods and
services, employment, inflation and economic growth.
Expansionary fiscal policy - examples of this would include decreasing taxes and / or increasing government expenditures, implemented to
fight recessionary pressures. A decrease in taxes means that households have more disposal income to spend, while a rise in government
spending provides and injection into the circular flow of national income.
Contractionary fiscal policy - examples of this would include increasing taxes and / or reducing government expenditures, implemented to
fight inflationary pressures. Both policies take money out of the circular flow of national income.
Spending multiplier - represents the multiple by which GDP increases or decreases in response to an increase and decrease in government
expenditures and investment.
Automatic stabilisers - so called because they act to stabilise economic cycles and are automatically triggered without additional
government action. Within fiscal policy this includes personal income taxes, which automatically fall as the national income declines and
transfer payments such as unemployment insurance and welfare payments.
TOK
● To what extent do political beliefs and ideologies influence a person’s
preference for one school of macroeconomic thought over another?
● It is often the case that two or more economists, observing an identical set of
macroeconomic data (national income accounts, inflation, unemployment),
arrive at very different explanations of events. How can this be accounted for?
Could this occur in a natural science?
● When evaluating economic policies, how important are cultural differences?
● How much statistical data should economists use in determining the reliability
of any economic policy result?
● Economists and those who use economic theory may disagree with each
other about the outcome of economic policies. On what basis might we make
judgments about their relative conclusions?

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Demand-Side Policies Fiscal

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Demand-side policies

1. Expansionary fiscal policy

Indirect taxes are imposed on expenditure

Transfer payments are payments made by the government without goods or

Capital expenditures (long-term)

Balanced, surplus & deficit

1. Be taxed by the government

Marginal propensity to save (MPS)

Marginal propensity to consume (MPC)

Marginal propensity to import (MPM)

MPT + MPS + MPC + MPM = 1

As such, an injection in the circular flow produces a chain reaction of further

Crowding occurs when increased government borrowing causes interest rates to

1. Incomes rise as national output increases

1. Incomes fall with national output

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