Fiscal Policy and the Public Finances
Fiscal policy is the government's use of taxation and public spending to influence aggregate demand and the wider economy.
Before you start
Make sure you're comfortable with these topics first:
Method
- Distinguish expansionary from contractionary fiscal policy, and state the intended effect on AD, a rightward shift for expansionary, leftward for contractionary, using the AD equation, since G is a direct component of AD and tax changes affect C via disposable income.
- Distinguish the budget balance, a single year's flow, deficit or surplus, from the national debt, the accumulated stock of past borrowing.
- Distinguish automatic stabilisers, which work without a new decision, e.g. benefit spending rising automatically in a downturn, from discretionary fiscal policy, a deliberate change to a tax rate or spending programme.
- Learn the multiplier link: a fiscal expansion's total effect on national income is the initial change in G, or the tax-induced change in C, multiplied by the fiscal multiplier, k = 1 / MPW.
- Learn the concept of crowding out: if a fiscal expansion is financed by government borrowing, this can raise interest rates as the government competes for loanable funds, or directly displace private-sector spending, partially offsetting the initial rise in AD.
- Learn direct versus indirect taxes, and progressive, proportional and regressive tax systems, and how each interacts with fiscal policy's effect on different income groups.
- For an evaluation question, weigh the size of the fiscal multiplier, the degree of crowding out, the state of the economy relative to full employment, and the effect on the budget deficit and national debt and its long-run sustainability.
Worked example
A government increases spending on infrastructure by 10bn, financed entirely by additional borrowing. The economy has a fiscal multiplier of 1.8 and significant spare capacity. Calculate the eventual total change in national income, ignoring any crowding-out effect, then explain one reason the actual rise in national income might be smaller than this.
- Identify the initial injection: a rise in government spending of 10bn.
- Apply the multiplier: total change in national income = k x initial change in G = 1.8 x 10bn.
- Calculate: 1.8 x 10 = 18bn, so national income would eventually rise by 18bn if the full multiplier effect worked through with no offsetting effects.
- Explain a reason the actual rise could be smaller: the extra borrowing needed to finance the spending could raise interest rates, discouraging some private investment and consumer spending, partially crowding out the initial injection and reducing the net rise in AD and national income below the full 18bn.
Practice questions
Try each question, then tap to reveal the answer.
Q1Distinguish expansionary from contractionary fiscal policy.Show answer
Answer: Expansionary fiscal policy raises government spending and/or cuts taxes to increase AD; contractionary fiscal policy cuts spending and/or raises taxes to reduce AD.
Q2Distinguish a budget deficit from the national debt.Show answer
Answer: A budget deficit is the shortfall between government spending and tax revenue in a single year; the national debt is the total accumulated stock of past borrowing still owed.
Q3Give one example of an automatic stabiliser.Show answer
Answer: Unemployment-related benefits, which rise automatically as more people become unemployed in a downturn, without any new government decision.
Q4What is meant by crowding out?Show answer
Answer: The idea that government borrowing to finance spending can raise interest rates or directly displace private-sector spending, offsetting some of the intended rise in aggregate demand.
Q5Distinguish between the budget deficit and the national debt.Show answer
Answer: The budget deficit is the amount by which government spending exceeds revenue in a single year, a flow; the national debt is the accumulated total of past borrowing, a stock. A falling deficit still adds to the debt.
Q6What is a progressive tax system?Show answer
Answer: A tax system in which the proportion of income paid in tax rises as income rises.
Q7A government cuts income tax, raising households' disposable income by 8bn. If the fiscal multiplier is 1.5, calculate the eventual total change in national income.Show answer
Answer: 1.5 x 8bn = 12bn.
Exam-style questions
Written in the style of a A Level Economics exam paper, with a full mark scheme.
Explain two ways in which contractionary fiscal policy could be used to reduce demand-pull inflation.
Show mark scheme
Tick each line you got. Your score builds from the marks on the scheme.
Nothing ticked yet - 6 available
Evaluate the effectiveness of an expansionary fiscal policy in raising a country's rate of economic growth.
Show mark scheme
Tick each line you got. Your score builds from the marks on the scheme.
Nothing ticked yet - 16 available
See real A Level Economics past-paper questions, with official mark schemes →
Free printable worksheet
Want more practice on paper? Download the fiscal policy and the public finances worksheet pack - 6 pages of exam-style questions with a full mark scheme. One email opens every download in this browser for 14 days - no account, no card. Print it for personal and classroom use.
Next topics
Not quite what you needed?
Tell us what is missing on fiscal policy and the public finances, or which topic to write up next. Every request is read, and we reply to every one.
Build a full practice pack.
This topic is one of hundreds in the library - pick the ones a student needs and generate a printable PDF in minutes.