Set out what fiscal policy aims to do and the tools it uses
The idea
Fiscal policy uses government spending and taxation to influence aggregate demand. Expansionary policy — higher spending or lower taxes — raises demand and is used when output is below potential; contractionary policy does the reverse. Some of the adjustment happens without any decision at all: unemployment benefits rise and tax receipts fall in a downturn, which is why they are called automatic stabilisers. Discretionary changes are the deliberate ones. Spending changes affect demand directly, while tax changes work through whatever fraction households and firms choose to spend rather than save.
A practice question
Which is an example of an automatic stabiliser?
- A newly legislated infrastructure programmeWhy not: Legislation is what makes it discretionary. A stabiliser operates without anyone deciding anything.
- Unemployment benefits rising as employment falls — correct
- A central bank cutting its policy rateWhy not: Monetary policy, and a deliberate decision at that. Stabilisers are fiscal and automatic.
Automatic stabilisers respond to conditions without new legislation, cushioning the cycle immediately. Infrastructure spending is discretionary and rate policy is monetary, not fiscal.
A harder one
Why does a spending increase usually affect demand more than a tax cut of the same size?
- Because part of a tax cut is saved rather than spent — correct
- Because spending is not subject to any multiplierWhy not: It is, and typically a larger one. The multiplier is why the first round of spending matters.
- Because tax cuts take effect more slowly by lawWhy not: A tax cut can reach pay packets within weeks, often faster than a spending programme can be built.
Government spending enters demand in full, whereas a tax cut enters only to the extent recipients spend it. The higher the propensity to save, the weaker the tax channel.
The hardest tier
A government runs a large deficit during an expansion. What concern does this raise?
- Automatic stabilisers will be disabledWhy not: Stabilisers operate regardless of the discretionary stance; a deficit does not switch them off.
- Inflation must fallWhy not: Adding demand into an expansion pushes prices up if anything, not down.
- It adds demand when none is needed — correct
It also leaves less capacity to respond to the next downturn. Stimulating an economy already near potential bids up prices rather than output, and it uses fiscal space that would be more valuable in a recession.
In the app: 9 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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