Fiscal & Monetary Policy

Fiscal policy is the government's use of its budget (its decisions on taxes and public spending) to influence the economy.

The government budget

The government budget is a plan of the government's revenue (mostly from taxes) and its spending over a period, usually a year.

The budget has two sides:

• Government revenue (mostly tax): income tax, corporation tax, VAT, excise duty, national insurance, capital gains tax, and so on.
• Government spending: public services (health, education), welfare (pensions, benefits), capital projects (roads, hospitals), and debt interest.

Comparing the two gives the budget position:

A budget surplus is when government revenue is greater than spending. A budget deficit is when government spending is greater than revenue, so the government has to borrow to fund the gap.

The size of a deficit or surplus is simply the gap between the two figures: budget balance = total revenue − total spending. A positive answer is a surplus; a negative answer is a deficit. Most governments run a small persistent deficit.

Reasons for government spending

Governments spend on several broad areas, each with its own purpose:

• Public services such as healthcare and education, to provide merit goods that would be under-provided by the market.
• Welfare and benefits such as pensions and unemployment benefit, to redistribute income and reduce poverty.
• Infrastructure such as roads, railways and ports, to lower firms' costs and support long-run growth.
• Defence, law and order, to provide public goods that markets will not supply.
• Debt interest, the unavoidable cost of past borrowing.

The way the government splits its spending across these areas affects growth, inequality and the other macroeconomic aims.

Expansionary fiscal policy

Expansionary fiscal policy lifts aggregate demand by raising government spending or cutting taxes (or both).

The mechanism: higher spending puts money directly into the economy (more infrastructure projects, higher welfare payments). Lower taxes leave households and firms with more disposable income, which they spend. Both channels raise aggregate demand (AD), which lifts real GDP and reduces unemployment.

Expansionary policy is used when the economy is in a recession or growing too slowly. The trade-off: if used too aggressively, it can trigger demand-pull inflation (topic 13).

Contractionary fiscal policy

Contractionary fiscal policy lowers aggregate demand by cutting government spending or raising taxes (or both).

The mechanism is the mirror image: higher taxes reduce disposable income; lower spending withdraws money from the economy. AD falls, which slows inflation but also slows growth and may raise unemployment.

Contractionary policy is used when inflation is too high or when the government deficit has become unsustainably large.

Limitations of fiscal policy

A 4-mark question often awards a final mark for a clear limitation. The main four:

• Time lags. Tax changes and new spending take months to years to feed through. Recognising the problem, passing the law, and waiting for the effect can leave fiscal policy acting after the economy has already moved on.
• Political constraints. Tax rises and spending cuts are unpopular with voters. Governments often avoid them even when they are economically right.
• The cost of funding it. A deficit has to be paid for by borrowing, and borrowing adds to debt interest, one of the main areas of government spending. Money that goes on servicing past debt is money that cannot be spent on other priorities in future budgets.
• Imperfect information. The government does not always know exactly where the economy is in the cycle, so its fiscal response may arrive late or be the wrong size.