1The idea in one paragraph

A government raises money and spends it, and both numbers are large enough to move the whole economy. Spending more, or taxing less, puts purchasing power into people's hands and pushes aggregate demand to the right. Spending less, or taxing more, takes it out and pulls aggregate demand to the left. That is fiscal policy: two instruments, used deliberately, to close the gap between where output is and where it could be. The rest of this unit is what a government raises and spends, the six things it is aiming at, how the two policies look on a diagram, how far one dollar of spending travels, and the long list of reasons the policy works less neatly than the diagram suggests.

2Who does what, before anything else goes wrong

This is the single most expensive confusion in the whole of macroeconomics, so settle it now.

Fiscal policy is the use of government spending and taxation by the government to influence aggregate demand. It is written into a budget, debated and voted on.

Monetary policy is the use of the money supply and interest rates by the central bank. Nobody votes on it. Section 3.5 is where it lives, and this unit does not repeat it.

Fiscal policy is the government, with taxation and spending. Monetary policy is the central bank, with interest rates. Both move AD, and neither moves the other's instrument.

In our imaginary economy, the Brindali government writes the budget and sets tax rates; the Central Bank of Brindal sets the interest rate. An answer that closes a deflationary gap here by "cutting interest rates" has answered the wrong question, however well it is written, and the marks for this unit are gone.

3The government's budget: what comes in, what goes out, what is left

Sources of revenue. The guide names four, and you should be able to sort any item in a data extract into one of them.

• Direct taxation — taxes on income and wealth, paid to the government by the person or firm charged: personal income tax, corporate income tax, taxes on property and inheritance.
• Indirect taxation — taxes on spending, collected by the seller as part of a price: value added tax or goods and services tax, and duties on fuel, alcohol and tobacco.
• Sale of goods and services from state-owned enterprises — where the state owns the railway, the postal service or the electricity company, the fares, stamps and bills are government revenue.
• Sale of government assets — selling a state-owned firm or a piece of public land. Notice what is different about this one: it is a one-off sum. Selling the railway raises money once and gives up the fares for ever, which is why relying on asset sales to fill a gap is a temporary fix.

Expenditures. Three kinds, and the distinction matters for what the spending does later.

• Current expenditure — the day-to-day cost of running public services: the wages of teachers, nurses and soldiers, medicines, fuel, maintenance. It buys this year's output and stops when the payments stop.
• Capital expenditure — spending that adds to the country's stock of capital: roads, railways, schools, hospitals, power stations. It raises aggregate demand now and the economy's productive capacity later, which is why it appears again in 3.7 supply-side policies.
• Transfer payments — money moved from one group to another with nothing produced in return: pensions, unemployment benefit, child benefit, disability payments. They are government spending, but they are not part of G in AD = C + I + G + (X − M), because nothing is bought with them at the moment of transfer. They raise AD through C instead, when the households who receive them spend the money.

Figure 1 puts the two lists side by side. Learn which list a term belongs to, because Paper 2 asks.

The budget outcome is what is left when you take one from the other over a year.

• A budget deficit: expenditure is greater than revenue. The gap has to be borrowed.
• A balanced budget: expenditure equals revenue.
• A budget surplus: revenue is greater than expenditure. The difference can repay past borrowing.

Now the distinction that decides a Paper 2 mark, and Figure 3 is worth ten minutes on its own.

The budget deficit is a flow: one year's gap, measured over that year. The government debt is a stock: everything still owed, measured on one date. Each year's deficit is added to the debt, and the debt costs interest, which becomes spending in next year's budget. So a country can cut its deficit for three years running and still owe more at the end than at the start. Only a surplus reduces the debt. If an extract says "the deficit fell", it has not said the debt fell.

4What fiscal policy is trying to achieve

Six goals. They are not all reachable at once, and saying which ones conflict is an evaluation point rather than a complaint.

Low and stable inflation. Contractionary fiscal policy takes spending out of the economy, which reduces demand-pull pressure on prices.

Low unemployment. Expansionary fiscal policy raises AD, firms produce more, and producing more takes more workers.

A stable economic environment for long-term growth. Firms commit to a factory that pays back over ten years only if they can guess what those ten years look like. Predictable taxes, steady public investment and a budget that is not in crisis make that guess possible.

Reducing business cycle fluctuations. The business cycle is the pattern of booms and recessions around an economy's trend. Fiscal policy leans against it: expansionary in a slump, contractionary in a boom, so the swings are smaller.

An equitable distribution of income. This goal is fiscal policy's alone, and it is the reason the policy cannot be replaced by monetary policy. Progressive taxation takes a rising share of higher incomes, and transfer payments and public services raise the living standards of the poorest. A central bank moving one interest rate can do none of that. Section 3.4 Economics of inequality and poverty has the machinery.

External balance. What a country buys from abroad staying roughly in line with what it sells. Contractionary fiscal policy cuts total spending, and some of that spending would have gone on imports, so the trade position improves.

Two of these pull against each other more often than not. An expansion that cuts unemployment tends to raise inflation and imports; a contraction that protects the external position and the price level costs jobs. That conflict is the substance of most part (b) answers in this unit.

5Expansionary and contractionary fiscal policy

Expansionary fiscal policy increases government spending, cuts taxation, or both, in order to increase aggregate demand. It is used against a deflationary gap, also called a recessionary gap: equilibrium real output below Yf, with unemployment and downward pressure on prices.

The chain is worth writing out in an answer, because the middle is what is marked. Higher G raises AD directly, because the government is buying output. Lower income tax raises households' disposable income, the income left after tax, so consumption rises. Lower corporate tax leaves firms more profit to reinvest, so investment rises. Higher transfer payments raise the incomes of households who spend nearly all of what they receive, so consumption rises again.

Your syllabus asks for this diagram in both schools, so Figure 4 draws both.

In the monetarist / new classical panel on the left, SRAS slopes upward and LRAS is vertical at Yf. AD₁ crosses SRAS to the left of LRAS, so there is a deflationary gap. The policy pushes AD right to AD₂, output rises from Y₁ to Yf, and the price level rises from PL₁ to PL₂. Closing a gap this way is never free, and saying so is evaluation rather than a mistake.

In the Keynesian panel on the right, the AS curve is flat while there is a great deal of spare capacity, rises as the economy approaches full employment, and is vertical at Yf, because nothing can be produced beyond it. That shape changes the answer to a question the left panel cannot ask: where the economy starts decides how much of the increase becomes output and how much becomes inflation. Starting on the flat section, as at A, extra AD raises output with almost no rise in the price level. Starting close to Yf, the same increase is mostly prices. This is the Keynesian case for spending in a deep recession and against spending in a boom.

Contractionary fiscal policy cuts government spending, raises taxation, or both, to reduce aggregate demand. It is used against an inflationary gap: equilibrium output above Yf, which an economy can only sustain by bidding up wages and prices.

In the monetarist / new classical panel, AD shifts left until output returns to Yf and the price level falls back from PL₁ to PL₂. In the Keynesian panel the economy is already on the vertical section at Yf, so output cannot fall as AD is cut back to the corner: the whole of the gap was in the price level, and the whole of the cure is a lower price level. That is the strongest version of the Keynesian claim, and it is worth one sentence in an answer that uses this diagram.

One rule keeps every diagram in this unit right. Fiscal policy shifts the AD curve. If your diagram moves SRAS, LRAS or the Keynesian AS curve, you have drawn a supply-side policy, and 3.7 is where that belongs.

9How well does fiscal policy work?

Part (b) marks live here, and a list of strengths followed by a list of weaknesses is not evaluation. A judgement that depends on something is.

Strength: it can target specific sectors and regions. A central bank has one interest rate for everybody. A government can build a railway in the region with the highest unemployment, cut tax for a particular industry, or fund training where the shortage is. When the problem is uneven, only fiscal policy can be aimed.

Strength: government spending is effective in a deep recession. This is the strongest claim in the unit. In a severe slump, the central bank's rate may already be near zero with nothing left to cut, and households and firms may be too frightened of the future to borrow at any rate. Monetary policy needs somebody who wants to borrow; a government that spends does not. It buys output directly, and section 6's multiplier is at its largest when there is spare capacity and crowding out is small.

Strength: it is the only demand-side policy that reaches the distribution of income. Progressive tax and transfer payments change who has what, which no interest rate can do.

Constraint: political pressure. Fiscal policy has to pass through politics, and politics has its own timetable. Raising taxes and cutting spending are unpopular, so contractionary policy is harder to enact than expansionary policy however much the economy needs it. Spending can also be aimed at winning elections rather than closing gaps, and some spending, once started, is close to impossible to withdraw.

Constraint: time lags.

Figure 10 lays them out. The data that show a recession arrive months after it began; a budget has to be written, debated and voted through; contracts have to be signed before any money is actually spent; and then the spending works through the economy round by round. By the time the policy bites, the economy may have turned without it, and a measure designed to lift a recession can arrive in the recovery and add to inflation instead. Compare 3.5, where a committee meets and the rate changes that day: the decision lag is the clearest advantage monetary policy has.

Constraint: sustainable debt. A deficit is borrowed, borrowing adds to the debt, and the debt has to be serviced. Sustainable debt means a level of borrowing a government can go on servicing without its interest payments crowding out everything else it wants to do. Three things follow. Interest payments are current expenditure, so a large debt eats the budget before any choices are made. Lenders demand a higher interest rate from a government they think may not repay, which makes the problem feed on itself. And a government already carrying a large debt has less room to expand the next time a recession arrives. What counts as sustainable depends on the interest rate, on the growth rate of the economy and on who the lenders are, so there is no single safe number, and anyone who gives you one is guessing.

Constraint (HL only): crowding out, from section 7.

Now the judgement, goal by goal. Against unemployment in a deep recession, fiscal policy is the stronger of the two demand-side tools, because it does not depend on anyone else being willing to borrow and because its multiplier and its diagram both work best when there is spare capacity. Against inflation, it is weaker than monetary policy in practice, not in theory: the contraction needed is a tax rise or a spending cut, and the political constraint makes those slow and unpopular, while a central bank can raise a rate on the day. For growth, the picture splits: capital expenditure raises demand now and capacity later, which is the best case fiscal policy has, while current spending raises demand alone, and a debt allowed to grow without limit lowers growth later by raising the cost of borrowing for everybody.

So the answer depends on the state of the economy and on the state of the public finances. In a deep recession, with spare capacity and room to borrow, fiscal policy is the instrument that works when the other one cannot. Near full employment, with a large debt and a nervous bond market, it is slow, politically constrained and partly crowded out, and the central bank has the better tool. Neither sentence is true on its own, and an answer that gives both, with the condition that separates them, is doing what "evaluate" means.