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's budget has two sides:

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

If revenue > spending, the government runs a budget surplus. If spending > revenue, it runs a budget deficit and has to borrow to fund the gap. Most governments run a small persistent deficit.

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.
• Crowding out. Heavy government borrowing can push up interest rates and squeeze private-sector investment. The boost from extra public spending is partly offset by less private spending.
• 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.