What fiscal policy is
Fiscal policy is the use of government spending and taxation to influence the economy. Expansionary policy (more spending or lower taxes) shifts AD right and is used against a recession. Contractionary policy (less spending or higher taxes) shifts AD left and is used against an inflationary gap.
The spending multiplier
An initial change in spending sets off rounds of further spending, so GDP changes by more than the first injection. The key number is the marginal propensity to consume (MPC), the share of an extra dollar of income that is spent. The rest, the marginal propensity to save (MPS = 1 − MPC), is saved.
Spending multiplier = 1 ÷ (1 − MPC) = 1 ÷ MPS
The tax multiplier is smaller in size and opposite in sign: −MPC ÷ (1 − MPC), since a tax change first affects disposable income and only the spent part feeds into demand.
Worked example
Assume MPC = 0.8 and a closed economy with no income taxes or imports leaking out.
- Spending multiplier = 1 ÷ 0.2 = 5.
- The government raises purchases by 20: GDP rises by 20 × 5 = 100.
- Check by rounds: 20, then 16 (0.8 × 20), then 12.8, ... the sum is 20 ÷ (1 − 0.8) = 100.
- Tax multiplier = −0.8 ÷ 0.2 = −4. A tax cut of 10 raises GDP by 10 × 4 = 40.
If a spending rise of 10 is matched by a tax rise of 10 (a balanced budget change), the net effect is 10 × 5 − 10 × 4 = +10: the balanced-budget multiplier is 1.
Real-world multipliers are smaller than this simple formula, because of taxes, imports, and higher interest rates (crowding out).
Automatic stabilisers and discretion
Automatic stabilisers, such as progressive income taxes and unemployment benefits, change budgets without a new law. In a recession, tax revenue falls and benefits rise, which cushions demand. Discretionary policy requires new decisions and faces lags: recognition, legislation and effect.
Deficits and debt
The budget deficit is spending minus revenue in a year. The national debt is the accumulated total of past deficits, net of surpluses. Economists often compare debt with GDP. If the interest rate on debt is lower than the growth rate of GDP, debt can fall as a share of GDP even with modest deficits. Large debts can raise interest costs and limit future options. How much debt is too much is debated, and the answer depends on interest rates and on what the borrowing buys.