Fiscal Policy Measures (Cambridge International IGCSE Economics)
Understanding fiscal policy
Spec point —
4.2.4· "Definition of fiscal policy Changes in: – taxes – government spending"
Understanding fiscal policy
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Fiscal policy involves the use of government spending and taxation (revenue) to influence total (aggregate) demand in the economy
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Fiscal policy is usually presented annually by the government through the Government Budget
- Fiscal policy can be expansionary in order to generate further economic growth
- Fiscal policy can be contractionary in order to slow down economic growth or reduce inflation
Fiscal policy measures
Spec point —
4.2.4· "Definition of fiscal policy Changes in: – taxes – government spending"
Fiscal policy measures
- When using fiscal policy, the government can change two main elements:
Changes in taxes
- Reducing taxes increases consumers’ disposable income and may encourage higher spending
- Increasing taxes reduces disposable income, lowering spending and potentially slowing inflation
Changes in government spending
- Increasing spending boosts demand for goods and services, creating jobs and encouraging growth
- Decreasing spending reduces total (aggregate) demand, which can slow inflation but may lead to higher unemployment
The effects of fiscal policy on macroeconomic aims
Spec point — how fiscal policy measures may enable a government to achieve its macroeconomic aims
- 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)
- From this, it is logical that changes to fiscal policy can influence any of these components – and often several of them at once
Expansionary fiscal policy
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Lower taxes and/or higher government spending
- Increases total (aggregate) demand in the economy, encouraging higher output and employment
- Useful during a recession to boost economic growth and reduce unemployment
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May risk higher inflation if total (aggregate) demand grows too quickly
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Can be directed towards sustainable growth by funding renewable energy, public transport, and green infrastructure
Contractionary fiscal policy
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Higher taxes and/or lower government spending
- Reduces demand in the economy, helping to control inflation
- Useful when the economy is overheating or inflation is high
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May slow growth and increase unemployment if used for too long
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Can support environmental sustainability by reducing subsidies for polluting industries and increasing taxes on harmful activities (e.g. carbon taxes)
Link to macroeconomic aims
| Macroeconomic aim | How fiscal policy can help achieve it |
|---|---|
| Economic growth | - Increase government spending on projects and cut taxes to encourage spending and investment |
| Lower inflation | - Raise taxes or reduce spending to lower total demand and reduce price pressures |
| Lower unemployment | - Fund job creation schemes and infrastructure projects, lower taxes to stimulate hiring |
| Healthy balance of payments | - Tax imports (tariffs) to reduce demand for foreign goods and support domestic industries |
| Fairer income distribution | - Use progressive taxes and targeted government spending to reduce inequality |
| Sustainability | - Fund renewable energy, protect natural resources and use environmental taxes to encourage greener behaviour |
Exam Hint When discussing sustainability in fiscal policy, focus on long-term benefits. For example: “Government investment in renewable energy creates jobs now while reducing future environmental costs"
Examples of fiscal policy
Spec point — Examples of fiscal policy
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 public spending in its 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 - Sustainability may worsen due to lower green subsidies being available |
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) - The Current Account is 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 |
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