Fiscal Policy

You’ll be able to

Distinguish expansionary from contractionary fiscal policy
Determine the spending or tax change needed to close an output gap
Explain how automatic stabilizers moderate the business cycle

Expansionary vs. contractionary fiscal policy

Fiscal policy is the use of government spending and taxation to influence aggregate demand. Expansionary fiscal policy — increasing government spending and/or cutting taxes — shifts AD right to close a recessionary gap, raising output and employment (at the cost of a larger budget deficit). Contractionary fiscal policy — decreasing spending and/or raising taxes — shifts AD left to close an inflationary gap, cooling the economy and easing inflation. The choice of tool depends on the gap: match expansionary policy to recessions and contractionary policy to overheating.

Sizing the policy to the gap

To close an output gap, the government must shift AD by the full size of the gap. Because of the multiplier, the required change in spending is smaller than the gap itself: divide the gap by the spending multiplier. Using taxes instead requires a larger change, because the tax multiplier is smaller — divide the gap by the tax multiplier (in absolute value). This is why, dollar for dollar, spending changes are the more powerful lever for moving GDP a given amount.

Automatic stabilizers

Automatic stabilizers are features of the budget that moderate the cycle without any new legislation. In a recession, tax revenue falls automatically (incomes drop) and transfer spending rises automatically (more people claim unemployment benefits and welfare) — both cushion the fall in AD. In a boom, the reverse happens: rising incomes push people into higher tax brackets and reduce transfer payments, restraining AD. Because a progressive tax system and transfer programs respond on their own, they dampen fluctuations faster than discretionary policy, which requires the slow process of new laws.

Spending needed to close a gap

Required ΔG = Output gap / Spending multiplier

Using taxes instead: Required ΔT = − Output gap / Tax multiplier. Because the tax multiplier is smaller, the required tax change is larger than the required spending change.

Worked example

An economy has a recessionary gap of $300 billion (real GDP is $300B below potential). The MPC is 0.75. How much must the government increase spending to close the gap through expansionary fiscal policy?

1.Find the spending multiplier: 1 / (1 − MPC) = 1 / (1 − 0.75) = 1 / 0.25 = 4.
2.The required spending change equals the gap divided by the multiplier: ΔG = 300 / 4.
3.ΔG = $75 billion.
4.Check: $75B × multiplier of 4 = $300B rise in GDP, exactly closing the gap.

Answer: The government must increase spending by $75 billion. Thanks to the multiplier of 4, this $75B injection expands AD by the full $300B needed to reach potential output.

Checkpoint

An economy is experiencing an inflationary gap. Which combination of fiscal policies is appropriate to return it to potential output?

Watch out

The required spending change to close a gap is not equal to the size of the gap — it is the gap divided by the multiplier. Setting ΔG equal to the full gap is a classic error that overshoots the target by the multiplier factor.

Checkpoint

During a recession, income tax revenue falls and unemployment benefit payments rise, even though the government has passed no new laws. This is an example of:

On the exam

Distinguish automatic stabilizers (built-in, no legislation — progressive taxes, unemployment benefits) from discretionary fiscal policy (new laws changing spending or tax rates). Free-response prompts often reward you for correctly classifying which one is at work.

Answer the 2 checkpoints as you read.