Fiscal Policy

Fiscal policy = government use of taxation and spending to influence AD.

Expansionary fiscal policy — raise AD:

• Increase G (infrastructure spending, public sector salaries, transfers).
• Cut T (income tax, corporation tax, VAT).
• Combination of both.

Used in recession (close recessionary gap).

Contractionary fiscal policy — lower AD:

• Cut G.
• Raise T.

Used when economy overheating (close inflationary gap).

Government spending categories:

• Current spending: salaries, benefits, day-to-day services.
• Capital spending: infrastructure (roads, schools, hospitals) — long-term investment.
• Transfer payments: cash to households (pensions, unemployment, child benefit).

Capital spending typically has larger multiplier than current spending.

Automatic stabilisers. Built-in fiscal responses that work WITHOUT a policy decision:

• Progressive tax — in recession, incomes fall, tax revenue falls FASTER (less drag on disposable income).
• Unemployment benefits — automatically rise when more people unemployed (cushioning fall in C).
• These smooth the business cycle automatically.

Discretionary fiscal policy. Active changes to spending or tax rates — e.g. stimulus packages (2009 ARRA in US, 2020-2021 pandemic supports).

Fiscal multiplier. A change in G (or T) generates a multiplied change in AD because initial spending generates further income → further spending → further income, etc.

$\text{Multiplier} = \frac{1}{1 - MPC} = \frac{1}{MPS + MRT + MPM}$

where MPC = marginal propensity to consume, MPS = marginal propensity to save, MRT = marginal rate of tax, MPM = marginal propensity to import.

Worked example. If MPC = 0.8, multiplier = 1/(1−0.8) = 5. A $10bn rise in G →$50bn rise in AD (in theory).

In reality, multipliers are SMALLER (1-2 in normal times, larger in deep recession when monetary policy can't respond).

Budget balance = T − G in a year:

• T > G: surplus.
• T = G: balance.
• T < G: deficit.

Public debt = cumulative past deficits (less surpluses).

Debt-to-GDP ratio = government debt ÷ GDP. Standard sustainability measure.

Debt sustainability depends on:

• Interest rate on debt: high rates mean more revenue needed just for interest.
• GDP growth: when growth > interest rate, debt-to-GDP can fall even with small deficits.
• Inflation: erodes real value of debt over time.
• Confidence of creditors: bond yields can spike if markets lose faith (Greek crisis 2010).

Sustainability rule (rough): if real GDP growth > real interest rate, debt-to-GDP stable with small deficits.

Costs of high public debt:

• High interest payments → less for other spending.
• Crowding out of private investment (if interest rates rise).
• Inter-generational equity — future taxpayers pay.
• Vulnerability to confidence shocks.
• May limit fiscal space in next crisis.

Benefits of borrowing:

• Smooth tax burden (don't raise taxes during recession).
• Fund productive infrastructure (returns exceed cost).
• Counter-cyclical stabilisation.
• Inter-generational sharing (current generation can borrow against future earning capacity).

Crowding out. Government borrowing raises interest rates → reduces private investment. Stronger when economy near full employment; weaker in recessions when private investment is anyway low.

Modern Monetary Theory (controversial) argues that countries issuing their own currency face no FINANCIAL constraint on spending — only INFLATION constraint. Critiqued as over-simplified but raised legitimate questions about debt limits.