IB Economics - Fiscal Policy and Short-Term Demand Management

This study note for IB Economics covers Fiscal Policy and Short-Term Demand Management

1. Introduction to Fiscal Policy

Fiscal policy involves the use of government spending and taxation to influence the economy. In the short term, fiscal policy can be used to manage aggregate demand (AD), which consists of the total spending in an economy, including consumption, investment, government expenditure, and net exports.

2. How Fiscal Policy Influences Aggregate Demand

• Government Expenditure: When the government increases its spending, it directly raises aggregate demand, as government spending is a component of AD. Increased government expenditure on public services (like healthcare and education), infrastructure projects, or defense can boost demand.
• Taxes: Changes in taxation influence household and business disposable income:
  • Personal Income Taxes: Lowering taxes increases disposable income for households, leading to higher consumption.
  • Corporate Taxes: Reducing corporate taxes can boost business profits, encouraging higher investment.

Together, these tools can help address short-term economic fluctuations, such as inflationary or recessionary gaps.

3. Expansionary Fiscal Policy and Deflationary (Recessionary) Gap

A deflationary gap occurs when aggregate demand is less than the economy's full-employment level, causing unemployment and unused capacity.

• Mechanism of Expansionary Fiscal Policy:
  1. Increase in Government Spending: The government might boost spending on infrastructure (like building roads, bridges, or hospitals), which directly increases AD.
  2. Tax Cuts: Reducing taxes (income or corporate) leaves households and firms with more disposable income, increasing consumption and investment.
  3. Multiplier Effect: The initial increase in AD leads to higher income, which then increases consumption further. This is known as the multiplier effect. For example, government spending on a construction project generates income for workers, who then spend their earnings on other goods and services.
  4. Closing the Gap: The increase in AD shifts the aggregate demand curve to the right, moving the economy towards full employment, thereby closing the recessionary gap.

Real-World Example: During the 2008 Global Financial Crisis, many countries, including the United States, implemented expansionary fiscal policies. The U.S. government, for instance, introduced the American Recovery and Reinvestment Act of 2009 (a $831 billion stimulus package) to boost demand through infrastructure investment and tax cuts.

4. Contractionary Fiscal Policy and Inflationary Gap

An inflationary gap occurs when aggregate demand exceeds the economy's full-employment level, causing demand-pull inflation.

• Mechanism of Contractionary Fiscal Policy:
  1. Decrease in Government Spending: Reducing government spending directly lowers AD, slowing down economic activity.
  2. Increase in Taxes: Raising taxes reduces disposable income for households and businesses, which lowers consumption and investment.
  3. Multiplier Effect in Reverse: The initial reduction in AD leads to lower income and further decreases in consumption, reinforcing the reduction in AD.
  4. Closing the Gap: The decrease in AD shifts the aggregate demand curve to the left, moving the economy towards a lower inflation rate, thus closing the inflationary gap.

Real-World Example: During the post-pandemic recovery period, many countries experienced inflationary pressures due to high consumer demand and supply chain disruptions. The U.S. Federal Reserve signaled fiscal tightening, alongside monetary policy tightening, to curb demand and control inflation.

5. Impact of Automatic Stabilisers

Automatic stabilizers are mechanisms that help smooth out fluctuations in the economy without explicit government intervention.

• Progressive Tax System: Taxes increase proportionally more than income as people earn more. During economic expansion:
  • Higher incomes lead to higher tax revenues, reducing disposable income and moderating AD.
  • During a recession, tax revenues fall as incomes drop, leaving more disposable income and mitigating the fall in AD.
• Unemployment Benefits: When economic activity slows down:
  • More people qualify for unemployment benefits, providing them with income even when they are out of work.
  • This maintains a certain level of consumption and prevents a more significant decline in AD.
  • Conversely, during an economic boom, fewer people claim benefits, reducing government spending automatically.

Real-World Example: During the COVID-19 pandemic, countries with strong social safety nets, such as Germany, used automatic stabilizers like unemployment benefits to support household incomes, which helped cushion the decline in AD.

6. Key Real-World Data

• U.S. Fiscal Deficit 2023: The U.S. fiscal deficit was around $1.4 trillion in 2023, highlighting the scale of government expenditure.
• OECD Average Unemployment Benefits: In 2022, the OECD countries spent an average of 2.1% of GDP on unemployment benefits.
• UK Tax Revenues: In 2021-2022, UK tax revenues amounted to 33% of GDP, illustrating the impact of progressive taxes as automatic stabilizers.

Glossary of Key Terms

• Aggregate Demand (AD): The total demand for goods and services in an economy at a given time.
• Automatic Stabilisers: Economic policies and programmes that counterbalance fluctuations without direct government intervention.
• Contractionary Fiscal Policy: Policy aimed at reducing aggregate demand through decreased government spending or increased taxes.
• Deflationary (Recessionary) Gap: The situation where aggregate demand is less than what is required for full employment.
• Expansionary Fiscal Policy: Policy aimed at increasing aggregate demand through increased government spending or reduced taxes.
• Inflationary Gap: The situation where aggregate demand exceeds the level consistent with full employment, leading to inflation.
• Multiplier Effect: The proportional increase in final income that results from an injection of spending.
• Progressive Tax: A tax system where the tax rate increases as the taxable amount increases.

Possible IB Economics Essay-Style Questions

1. Explain how expansionary fiscal policy can be used to close a deflationary gap.
2. Discuss the effectiveness of automatic stabilizers in managing short-term economic fluctuations.
3. Evaluate the use of contractionary fiscal policy in reducing inflationary pressures in an economy.
4. To what extent can fiscal policy effectively manage short-term demand in the face of global economic shocks?

Retrieval Questions for A-Level Students

1. What is fiscal policy?
2. How can government expenditure affect aggregate demand?
3. What is the difference between expansionary and contractionary fiscal policy?
4. Define automatic stabilizers and give two examples.
5. Explain the multiplier effect in the context of fiscal policy.
6. What happens to aggregate demand when the government cuts taxes?
7. How does a progressive tax system help stabilize an economy?
8. What is a deflationary gap and how can fiscal policy address it?
9. Why might a government want to reduce its spending during an inflationary period?
10. How did the U.S. government respond fiscally to the 2008 financial crisis?