Fiscal Policy Measures (Cambridge (CIE) O Level Economics)

Revision Note

Written by: Steve Vorster, Economics & Business Subject Lead

Reviewed by: Jenna Quinn, Head of New Subjects

Fiscal Policy involves the use of government spending and taxation (revenue) to influence total (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

To understand the effects of fiscal policy on an economy, it is useful to know how total demand (gross domestic product) is calculated
Total (aggregate) demand = household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
- Total demand = C + I + G + (X - M)
From this, it is logical that changes to fiscal policy can influence any of these components - and often several of them at once

Examples of the Impact of Contractionary Fiscal Policy

Example 1	The Government increases income tax levels
Effect on the economy	Consumers pay more tax → discretionary income reduces → consumption reduces → total demand reduces
Impact on macroeconomic aims	Economic growth slows down Inflation eases Unemployment may increase as output is falling and fewer workers are required Current Account 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 → total demand decreases
Impact on macroeconomic aims	Economic growth slows down Inflation eases Unemployment may increase as output is falling Current Account 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 → total demand decreases
Impact on macroeconomic aims	Economic growth slows down Inflation eases Unemployment may increase as output is falling Current Account Improves (with less income, imports may fall) Less corporation tax available for redistribution

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 → total demand increases
Impact on macroeconomic aims	Economic growth increases Inflation rises Unemployment may decrease as output is rising which requires more workers Current Account - 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 → total demand increases
Impact on macroeconomic aims	Economic growth increases 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) Current Account 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

Example 2

The Government increases unemployment benefits

Effect on the economy

Household income increases → consumption increases → total demand increases

Impact on macroeconomic aims

Economic growth increases
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)
Current Account 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

Spending can be targeted on specific industries
Short time lag as compared with monetary policy (effects of fiscal policy are seen sooner)
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 total supply of an economy
- E.g. Building a new airport immediately increases government spending and total demand, but when it is built, the potential output will have increased (Production Possibility Curve has shifted outward)

Policies can fluctuate significantly when new governments are elected
- Long term infrastructure projects may lack follow-through
Increased government spending can create budget deficits
- Repaying this debt may lead to austerity on future generations
Conflicts between objectives
- E.g. Cutting taxes to increase economic growth may cause inflation

Last updated: 18 June 2024

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