Fiscal policy is the use of the federal government's budget — its spending (G) and taxation (T) — to influence the level of economic activity. It is one of the two main demand-management tools (the other, monetary policy, is the next lesson), and it works by shifting aggregate demand.
Objectives and the budget balance
The government uses fiscal policy to pursue its economic objectives — strong and sustainable growth, low unemployment, low and stable inflation, and a sustainable budget position. The budget balance compares revenue and spending: a balanced budget (T = G), a surplus budget (T > G) or a deficit budget (G > T).
Automatic stabilisers vs discretionary policy
Automatic stabilisers — progressive taxes and unemployment benefits — change automatically with the cycle, cushioning it without any new decision: in a downturn, tax take falls and benefits rise, supporting demand. Discretionary fiscal policy is a deliberate change in spending or tax rates announced by the government.
Fiscal stance on the AD/AS model
An expansionary stance (higher G and/or lower T) raises aggregate demand; a contractionary stance (lower G and/or higher T) reduces it. The diagram shows an expansionary stance closing a recessionary gap — note how the effect is amplified by the multiplier from the AE lesson.
Strengths and weaknesses
Strengths: can target specific sectors or regions; automatic stabilisers act instantly; powerful in a deep downturn when monetary policy is constrained. Weaknesses: implementation lags (it must pass Parliament and be rolled out); political constraints; the risk of rising debt; and possible crowding out of private investment if extra borrowing pushes up interest rates.
Classify stances and trace them on the model together.
Identify the stance
For each, state the stance (expansionary/contractionary), the AD direction, and the likely budget effect: (a) a cut in income tax rates; (b) a freeze on public-sector hiring and spending to cool an overheating economy; (c) automatic rise in unemployment benefits during a recession.
1. Define a balanced, a surplus and a deficit budget in terms of government spending and taxation revenue.
2. Using the AD/AS model, explain and illustrate the effect of an expansionary fiscal stance. State when a government would adopt it.
3. Distinguish between automatic stabilisers and discretionary fiscal policy, giving an example of each.
4. Outline two strengths and two weaknesses of fiscal policy as a tool for managing the economy.
5. Explain how a budget deficit is financed and why the resulting government debt is not necessarily a problem.
6. Using the AD/AS model, explain how a contractionary fiscal stance could be used to reduce inflationary pressure.