Demand management: fiscal policy

Direct tax: levied directly on income or wealth — the payer cannot pass the burden on (e.g., income tax, corporation tax). Indirect tax: levied on spending/goods — the burden can be passed to consumers through higher prices (e.g., VAT/GST, excise duties, tariffs).

The use of government spending (G) and taxation (T) to influence aggregate demand, output, and employment in the economy. It is a demand-side tool — fiscal changes shift the AD curve.

Progressive: tax rate rises as income rises (e.g., most income taxes). Regressive: takes a larger % from lower earners (e.g., flat-rate VAT — same rate, bigger share of a poor person's income). Proportional (flat): same % regardless of income.

Current (recurrent) spending: day-to-day costs (wages, healthcare, welfare). Capital spending: investment in infrastructure (roads, hospitals, schools). Transfer payments: payments where no good or service is received in return (pensions, unemployment benefits, subsidies).

Transfer payments (pensions, benefits, subsidies) do not involve the government purchasing goods or services — no output is produced. They redistribute income. They affect AD indirectly: when recipients spend transfer income, it increases C (consumption), not G.

Progressive taxes take a higher percentage from higher earners, generating revenue that can be redistributed through transfers and public services to lower-income groups. This narrows the gap between rich and poor and shifts the Lorenz curve toward equality.

G represents government spending on goods and services only — such as paying public employees, building infrastructure, and purchasing equipment. It does NOT include transfer payments like pensions or unemployment benefits.

VAT is charged at the same rate on goods regardless of the buyer's income. Since lower-income households spend a larger proportion of their income on consumption, VAT takes a bigger share of their income compared to wealthier households who save more.

Building roads, railways, hospitals, and schools; investing in renewable energy projects; constructing broadband networks. Capital spending increases the productive capacity of the economy and can shift both AD right (short run) and LRAS right (long run).

Direct taxes: income tax, corporation tax, capital gains tax, inheritance tax. Indirect taxes: VAT/GST, excise duties (on alcohol, tobacco, fuel), tariffs (on imports), environmental taxes (carbon tax). Direct taxes are on income/wealth; indirect taxes are on spending.

Increasing government spending (G↑) and/or cutting taxes (T↓). More disposable income → C rises. More G → AD shifts right. Used to close a deflationary (recessionary) gap — boost output and reduce unemployment. Leads to a budget deficit if spending exceeds tax revenue.

Decreasing government spending (G↓) and/or raising taxes (T↑). Less disposable income → C falls. Less G → AD shifts left. Used to close an inflationary gap — reduce demand-pull inflation. Creates a smaller deficit or a budget surplus.

Fiscal policy is implemented by the government (through parliament/congress passing spending and tax legislation). Monetary policy is implemented by the central bank (setting interest rates). Both shift AD, but through different channels and with different decision-making processes.

During a recession or deflationary gap — when output is below potential, unemployment is high, and AD is insufficient. The government increases G or cuts T to boost spending, shift AD right, and close the output gap.

Expansionary fiscal policy means G↑ or T↓ (or both). If the government spends more than it receives in tax revenue, it runs a budget deficit. The deficit must be financed by borrowing, which adds to the national debt.

When increased government borrowing (to finance a deficit) drives up interest rates, making it more expensive for the private sector to borrow and invest. The increase in G is partially offset by a fall in private I, reducing the effectiveness of expansionary fiscal policy.

Built-in features of the tax and transfer system that automatically dampen economic fluctuations without any deliberate government action. Key examples: progressive income tax and unemployment benefits. They smooth the business cycle automatically.

Budget deficit: government spending exceeds tax revenue in a given year — the shortfall must be financed by borrowing. Budget surplus: tax revenue exceeds government spending — the surplus can be used to repay debt. The deficit is a flow measure (this year's gap).

Political constraints (tax hikes unpopular), time lags (slow to identify, legislate, and implement), crowding out (borrowing → higher rates → less I), rising national debt, potential government inefficiency, and inflationary risk if used near full employment.

Incomes fall → people pay less income tax (progressive tax: lower income = lower rate). More people claim unemployment benefits. Both cushion disposable income → C doesn't fall as sharply → the AD contraction is softened without any policy decision.

The total accumulated amount a government owes from years of borrowing — the sum of all past budget deficits minus surpluses. It is a stock measure (total owed), unlike the deficit which is a flow (this year's shortfall).

Can target specific sectors or regions (unlike monetary policy). Effective when monetary policy hits the zero lower bound (liquidity trap). Automatic stabilisers smooth the cycle without lag. Can address inequality directly through progressive taxation and transfers.

The deficit is a flow (this year's shortfall between spending and revenue). The debt is a stock (total accumulated borrowing over time). A government can have a small deficit but a large debt built up over decades of persistent deficits.

Incomes rise → people pay more income tax (progressive: higher income = higher rate). Fewer claim unemployment benefits. Both constrain disposable income growth → C doesn't rise as fast → the AD expansion is softened, reducing inflationary pressure.

High debt means large interest payments — reducing money available for public services (opportunity cost). It may reduce investor confidence, push up borrowing costs, and limit the government's ability to use fiscal policy during future crises.

In a liquidity trap, interest rates are near zero and monetary policy is ineffective (people hoard cash rather than borrow). Fiscal policy — directly increasing G or cutting T — can still boost AD because the government itself spends, bypassing the broken monetary transmission mechanism.

Automatic stabilisers are built into the system and activate without any policy decision (e.g., progressive tax, benefits). Discretionary fiscal policy requires deliberate government action — passing new legislation to change G or T. Automatic stabilisers have no decision lag.

They smooth the business cycle without any decision lag — they kick in immediately as conditions change. This avoids the time lag problem of discretionary policy (identifying the problem, passing legislation, implementing changes). They work every time, automatically.

Japan's debt exceeds 260% of GDP — the highest in the developed world. US debt surpassed $34 trillion in 2024. Both ran persistent deficits, especially after the 2008 crisis and COVID-19 stimulus programmes.

Tax increases are deeply unpopular with voters, so politicians avoid them even when contractionary policy is needed. Spending projects may be directed to politically favourable areas rather than where they're most needed. Short election cycles encourage short-term thinking over sound fiscal management.

The multiplier shows how an initial change in spending leads to a LARGER final change in GDP. Basic formula: k = 1 / (1 − MPC) = 1 / MPS, where MPC = marginal propensity to consume. If MPC = 0.8, k = 1/(1−0.8) = 1/0.2 = 5. A $100m injection → $500m increase in GDP.

Government spends $100m on roads → construction workers earn $100m → they spend 80% = $80m at shops → shop workers earn $80m → spend 80% = $64m → ... Each round, spending 'leaks' out (savings, tax, imports) but the remainder is re-spent. Total = $100m + $80m + $64m + ... = $500m (geometric series).

Larger MPC → larger multiplier (more re-spending per round). Smaller withdrawals (savings, taxes, imports) → larger multiplier. In the open economy formula: k = 1/(MPS + MPT + MPM). Higher MPS, MPT, or MPM → smaller k. Developing countries often have larger multipliers (less leakage to imports).

MPC = ΔC/ΔY (fraction of extra income spent on consumption). MPS = ΔS/ΔY (fraction saved). MPT = ΔT/ΔY (fraction taken as tax). MPM = ΔM/ΔY (fraction spent on imports). They sum to 1: MPC + MPS + MPT + MPM = 1 (approximately, in a simplified model with MPC capturing only domestic consumption).

MPS = 1 − MPC − MPT − MPM = 1 − 0.6 − 0.15 − 0.1 = 0.15. Or: k = 1/(1 − MPC_domestic) where leakages = MPS + MPT + MPM = 0.15 + 0.15 + 0.1 = 0.40. k = 1/0.40 = 2.5. So a $100m injection → $250m increase in GDP.

A higher MPM means more of each spending round LEAKS OUT to imports rather than being re-spent domestically. Imports are WITHDRAWALS from the circular flow — money flows abroad rather than creating domestic income. Small open economies (like Singapore) tend to have high MPM → small multiplier.

The negative multiplier works in the SAME WAY but in reverse. A WITHDRAWAL from the circular flow (e.g. cut in government spending, fall in investment, rise in taxes) leads to a MULTIPLIED fall in GDP. ΔY = k × (−ΔG). If k = 5 and G falls by $20m → GDP falls by $100m.

1) TIME LAGS: spending takes time to flow through. 2) Spare capacity needed (near full employment → inflation, not real growth). 3) Confidence: households may SAVE more during uncertainty (lower MPC). 4) Crowding out: government borrowing → higher interest rates → less private investment. 5) Supply constraints.

KEYNESIANS: emphasise the multiplier — government spending effectively boosts GDP, especially in recessions (spare capacity, high MPC from transfers to the poor). CLASSICAL/MONETARIST: multiplier is small in practice due to crowding out, Ricardian equivalence (households save more anticipating future taxes), and long-run LRAS being vertical.