Step 9: Fiscal Policy

What fiscal policy is

Imagine your town council builds a new bus station. The builders it pays spend part of their wages in local cafés and shops. Or imagine the government cuts income tax: your take-home salary rises and you spend some of the extra. Either way, total spending rises.

Fiscal policy is the use of government spending and taxation to influence aggregate demand. Both appear in the expenditure identity \( AD = C + I + G + (X – M) \): government purchases are G, and taxes affect C by changing disposable income.

• Expansionary fiscal policy: raising G or cutting taxes to increase AD. It widens the budget deficit.
• Contractionary fiscal policy: cutting G or raising taxes to reduce AD. It narrows the deficit. Also called austerity or consolidation.

Not all spending is equal. Government purchases of goods and services (building a hospital, employing a nurse) enter AD directly and in full. Transfer payments, such as pensions and unemployment benefit, are not part of G, because no output is bought. They only raise AD to the extent that recipients spend them, which depends on the marginal propensity to consume (MPC). So $1 of public investment moves AD by more than $1 of tax cut. This is also why the balanced budget multiplier is positive: raising G and taxes by equal amounts still expands AD, because all of the extra G enters demand while only MPC times the tax rise leaves it.

As you saw in the step on aggregate demand, the multiplier depends on leakages from the circular flow:

where MPS is the marginal propensity to save, MPT the marginal tax rate and MPM the marginal propensity to import.

Automatic stabilisers

The most important fiscal policy is the one nobody votes for. When an economy enters recession, incomes fall, so income tax and corporation tax receipts fall automatically. Unemployment rises, so benefit payments rise automatically. The budget moves into deficit, and that deficit puts money into the hands of the households whose incomes have just fallen. AD is cushioned. In a boom the reverse happens: tax revenue surges, benefit spending falls, and the expansion is held back.

They have three big advantages over discretionary fiscal policy (deliberate changes that need legislation):

1. No lags. They act the moment incomes fall, with no delay for recognising the problem, passing a law or setting up a programme.
2. Well targeted. Support goes to the people whose incomes fell, who tend to spend most of any extra money.
3. Self-reversing. They switch off as recovery comes, so no politician has to vote to end a popular programme.

Their size helps explain why post-war recessions have been milder: in 1929 the US federal government spent about 3% of GDP.

Cyclical and structural deficits

Because the deficit moves with the economic cycle, the headline number tells you little about the government’s real fiscal stance. Economists split it in two:

Cutting spending to remove a cyclical deficit deepens the recession; ignoring a structural deficit lets debt pile up in a boom. But potential output cannot be observed: in 2007 the IMF and OECD thought Spain and Ireland had structural surpluses, when both had large structural deficits.

A related measure is the primary balance: the budget balance excluding interest payments on existing debt. It shows the current fiscal stance, since interest is a legacy of past borrowing.

Crowding out, crowding in and Ricardian equivalence

The main objection to fiscal expansion is crowding out. To finance a deficit the government sells bonds, competing with firms for a fixed pool of saving. That pushes up interest rates and reduces private investment. If the offset is complete, fiscal policy only changes the mix of output, not its level.

The chapter’s key point is that this depends on the state of the economy:

• Severe at full employment, because resources are already in use and must be taken from someone.
• Negligible in a deep recession, because idle resources exist and saving is earning nothing.
• Negligible at the zero lower bound, because the central bank is holding interest rates at zero, so they cannot rise.

So the objection is weakest exactly when stimulus is usually proposed: in recessions. There is also crowding in: public investment in roads, education or research can raise the return on private capital, and strong expected demand encourages firms to invest.

Ricardian equivalence says rational households save a deficit-financed tax cut to pay tomorrow’s taxes. But it needs unrealistic assumptions; after the 2008 US tax rebates the MPC was estimated at 0.2 to 0.4, not zero.

When is debt dangerous? The r minus g rule

What matters is not whether debt is large but whether the debt-to-GDP ratio is stable. A ratio has a denominator, and GDP grows.

Here \(r\) is the nominal interest rate on government debt and \(g\) is nominal GDP growth (real growth plus inflation). If \(r > g\), the debt ratio grows unless the government runs a primary surplus. If \(r < g\), the ratio shrinks even with a primary deficit, because the economy outgrows its debt.

This explains history. The UK cut its post-war debt from above 250% of GDP to under 50% by the 1970s without large surpluses, because growth beat interest rates. Greece faced interest above 15% while its economy shrank, so its debt ratio rose from 146% to 180% even as the deficit was cut. European austerity after 2010 assumed a multiplier of about 0.5; Blanchard and Leigh (2013) found it was between 0.9 and 1.7. As Keynes wrote in 1937, “the boom, not the slump, is the right time for austerity.”

Practise: 6 questions

Try each one on paper first, then check the worked answer.

Check yourself

The short version

• Fiscal policy uses G and taxes to shift AD. The deficit is a yearly flow; the debt is a stock that only a surplus reduces.
• Government purchases enter AD in full; transfers only through the MPC. The multiplier is \( \frac{1}{MPS + MPT + MPM} \).
• Automatic stabilisers act with no lag, are well targeted and switch themselves off. The cyclical deficit needs no action; the structural deficit does.
• Crowding out is severe at full employment but small in a deep recession or at the zero lower bound. Ricardian equivalence is a limiting case.
• Debt dynamics: \( \Delta(D/Y) \approx (r – g)(D/Y) – \text{primary balance} \). If growth beats interest, debt shrinks without austerity.

This guide covers the core of Chapter 28 of Economics Made Simple. For the full chapter, with the European austerity case study and 15 exam-style questions with a complete answer key, see the book.