Fiscal Policy: The Sequel – When Governments Go Big or Go Home

Fiscal Policy: The Sequel – When Governments Go Big or Go Home

In our last episode, we covered the basics of fiscal policy. Now it's time to turn it up to eleven and see what happens when governments really flex their economic muscles. Grab your popcorn (or your economics notes) - things are about to get interesting.

Expansionary Fiscal Policy: The Economic Sugar Rush

Imagine your economy is like a tired student during exam season. It's sluggish, underperforming, and desperately in need of a boost. What do you do? If you're the government, you reach for expansionary fiscal policy - the economic equivalent of a triple espresso and a Red Bull chaser.

Expansionary fiscal policy happens when the government:

1. Increases its spending (more money for schools, roads, NHS, etc.)

2. Cuts taxes (letting people and businesses keep more of their cash)

3. Or does both at once (the full economic caffeine hit)

The goal? To jolt the economy awake by pumping up aggregate demand and closing that pesky deflationary (or recessionary) gap.

Real-world example: During the 2008 financial crisis, the UK government cut VAT from 17.5% to 15% and accelerated £3 billion of capital spending to stimulate the struggling economy. More recently, during the pandemic, Rishi Sunak's "Eat Out to Help Out" scheme subsidised 100 million meals in August 2020 to boost the hospitality sector - classic expansionary policy in action!

The Keynesians vs The Monetarists: Economic Fight Club

This is where economics gets spicy - like watching Marvel vs DC, but with more graphs and fewer capes.

In the Left Corner: The Keynesians

Team Keynes believes governments should actively intervene during economic downturns. Their playbook says:

1. Boost government spending (G) during recessions

2. This directly increases aggregate demand (remember AD = C + I + G + X - M)

3. The economy grows and unemployment falls

4. Once the economy recovers, you can worry about inflation

Keynesians argue that without government intervention, economies can get stuck in recessions for years - like a Netflix auto play loop of economic misery.

Real-world example: President Biden's $1.9 trillion American Rescue Plan in 2021 was textbook Keynesian policy - massive government spending to pull the economy out of its pandemic slump.

An economist would imagine the situation like this:

• Expansionary fiscal policy increases AD from AD1 to AD2, boosting real GDP from Y0 to Y1 As there is no pressure on the general price level along this section of the Keynesian AS curve, prices remains at PL1.

• If these expansionary policies are continued, then AD will increase from AD2 to AD3 which leads to an increase in real GDP from Y1 to Y2 and hence an increase in economic growth and lower unemployment. However, this will add inflationary pressure as the average price level rises from PL1 to PL2.

• If AD is allowed to continue to expand from AD3 to AD4, the change in real GDP from Y2 to YF would be less than the change in the average price level from PL2 to PL3 due to the increasing scarcity of factors of production.

• SM2 (which is the money supply curve after expansionary fiscal policy) intersects the money demand curve at r1, the lowest interest rate. This makes sense in a Keynesian model, as an increase in the money supply typically leads to lower interest rates, ceteris paribus.

• SM1 is the original money supply curve (before the fiscal expansion). The interest rate re (equilibrium rate) occurs when the money demand curve intersects the original money supply curve sM1, which is at a higher interest rate than r1. This is the typical equilibrium interest rate before fiscal expansion.

• SM3 represents the money supply after further fiscal expansion (even more money is injected into the economy).

In the Right Corner: The Monetarists

The Monetarists (led by the late economist Milton Friedman - think of him as the Thanos of economic theory) have a different view:

1. Expansionary fiscal policy just creates inflation in the long run

2. Money supply matters more than government spending

3. The free market will fix itself if left alone

4. Supply-side policies (improving productivity) are what really drive growth

Real-world example: Margaret Thatcher's economic policies in the 1980s were heavily influenced by monetarist thinking - focusing on controlling inflation rather than reducing unemployment.

An economist tends to imagine the situation like this:

• Monetarists argue the use of demand-side policies simply creates inflationary pressures as average prices rise from PL1 to PL2, without changes in the full employment level of real national output (YF).

The Keynesian Multiplier: When £1 Becomes More Than £1 (HL Students, This Is Your Jam)

Now, here's where it gets properly mind-blowing. Keynesians argue that when the government injects money into the economy, the final impact is much larger than the initial amount. It's like economic magic - but with actual math to back it up.

Here's how it works:

1. The government spends £100 million on a new hospital

2. The construction workers, architects, and suppliers get paid

3. They spend most of their earnings at shops, restaurants, and services

4. Those businesses then have more money to pay their employees

5. Who then spend their money elsewhere... and on and on it goes

This chain reaction is known as the Keynesian multiplier. The initial government spending creates a ripple effect throughout the economy, with the total impact being several times larger than the original amount.

Real-world example: Studies of the 2009 UK fiscal stimulus estimated a multiplier of about 1.5, meaning every £1 of government spending generated around £1.50 in total economic activity. Not a bad return!

The Multiplier Formula (For You Math Nerds)

The Keynesian multiplier can be calculated using either:

• 1 ÷ (1 − MPC)

• 1 ÷ (MPS + MPT + MPM)

Where:

• MPC is the Marginal Propensity to Consume (how much of each extra £1 people spend). The MPC = ∆C + ∆Y, where C = consumption and Y = income. The higher the MPC, the larger the multiplier effect.

• MPS is the Marginal Propensity to Save (how much they save). The MPS = ∆S ÷ ∆Y. The higher the MPS; the lower the Keynesian multiplier will be as more money leaks from the circular flow of income.

• MPT is the Marginal Propensity to Tax (how much goes to taxes). b) The MPT = ∆T ÷ ∆Y. The higher an economy’s marginal tax rates are, the lower the Keynesian multiplier will be as more money is withdrawn from the economy.

• MPM is the Marginal Propensity to Import (how much is spent on foreign goods). The MPM = ∆M ÷ ∆Y. So, if households spend a larger proportion of extra income on imports, the value of the Keynesian multiplier will fall.

In the UK, the MPC is around 0.9 (meaning people spend about 90p of each extra £1 they receive). If we ignore taxes and imports for simplicity:

Multiplier = 1 ÷ (1 - 0.9) = 1 ÷ 0.1 = 10

This would mean £1 billion in government spending could theoretically generate £10 billion in economic activity!

But wait – it's not that simple (economics never is). The multiplier gets smaller when:

• People save more of their money (higher MPS)

• More money leaks out to imports (higher MPM)

• Tax rates are higher (higher MPT)

Real-world example: Small, open economies like Singapore have smaller multipliers (around 1.3) because they import so much. Meanwhile, large economies like the US have larger multipliers (around 1.6-2.0) because more spending stays within the domestic economy.

Contractionary Fiscal Policy: The Economic Cold Shower

What about when the economy is overheating like a phone running too many apps? That's when governments reach for contractionary fiscal policy – raising taxes and / or cutting spending to cool things down.

Think of it as the economic equivalent of a parent confiscating your PlayStation because you've been playing Fortnite instead of studying. Nobody likes it, but sometimes it's necessary.

Real-world example: After the 2010 UK election, the Coalition government implemented austerity measures, cutting public spending by around £30 billion and raising VAT to 20% to reduce the budget deficit following the financial crisis. Whether this was good timing is still hotly debated by economists (seriously, mention "austerity" at an economics conference and watch the chaos unfold).

When Fiscal Policy Gets Complicated: The Constraints

Unfortunately, fiscal policy isn't as simple as pressing an "economic boost" or "economic brake" button. There are some serious limitations:

1. Political Pressures: Economics Meets Reality TV

Politicians often make fiscal decisions based on what will get them re-elected rather than what's best for the economy. Tax cuts right before an election? Shocking, I know!

Real-world example: The 2019 UK election saw both major parties promising massive spending increases - with the Conservatives pledging an extra £20.5 billion for the NHS by 2023 / 24. Economic necessity or vote-winning strategy? You decide.

2. Time Lags: Economics Isn't Instagram

Fiscal policy moves about as quickly as your grandparents figuring out how to use Zoom. By the time tax changes or spending programs actually happen, the economic problem / environment might have changed completely.

Real-world example: The UK's response to the 2008 financial crisis included infrastructure projects that weren't completed until years later - when the economy was already in a different phase of the business cycle.

3. Debt Sustainability: The National Credit Card Has Limits

Running budget deficits (spending more than tax revenue) is fine temporarily, but eventually, the bill comes due. Countries with high debt levels have less fiscal "firepower" available.

Real-world example: UK government debt reached about 100% of GDP following the pandemic - the highest level since the 1960s. This limits how much additional spending the government can undertake without worrying about interest payments consuming the budget.

4. The Crowding Out Effect: When Government Hogs the Financial Buffet (HL Students, Pay Attention)

When governments borrow heavily, they push up interest rates, making it more expensive for private businesses to borrow and invest. It's like when your sibling uses up all the hot water - there's less for everyone else.

Real-world example: Some economists argued that Gordon Brown's high public spending in the early 2000s contributed to higher interest rates, reducing private investment - though the evidence for significant crowding out in the UK has been mixed.

Economists see it like this: An increase in government demand for borrowed funds (to finance its budget deficit) leads to an increase in interest rates from r1 to r2. This results in private sector firms being able to borrow only Q2 loanable funds, but those who borrow are charged the higher interest rate of r2.

The Strengths: Why Fiscal Policy Is Still in the Game

Despite these limitations, fiscal policy remains a powerful tool:

1. Precision Targeting: The Economic Sniper Rifle

Unlike broader monetary policy, fiscal measures can target specific sectors, regions, or income groups.

Real-world example: The UK's "levelling up" agenda aims to target government spending at economically deprived areas, particularly in the North of England. The £4.8 billion Levelling Up Fund launched in 2021 is designed to reduce regional inequalities – something monetary policy simply couldn't achieve.

2. Effective in Deep Recessions: The Economic Defibrillator

When interest rates are already near zero and confidence is shattered, fiscal policy might be the only thing powerful enough to restart the economic heart.

Real-world example: The UK's furlough scheme during COVID-19 cost around £70 billion but prevented mass unemployment when many businesses couldn't operate. No other policy tool could have achieved this.

3. Automatic Stabilisers: The Economic Shock Absorbers (HL Content Alert!)

Some fiscal mechanisms kick in automatically to smooth out economic cycles:

Automatic Stabiliser 1 - Progressive Taxes: Higher earners pay more during booms, automatically reducing overheating.

Real-world example: In the UK, someone earning £30,000 pays a 20% income tax rate, while someone earning £200,000 pays 40% on most of their income. During economic booms, more people move into higher tax brackets, automatically reducing disposable income and cooling the economy.

Automatic Stabiliser 2 - Unemployment Benefits: Support payments increase during downturns, automatically supporting spending.

Real-world example: UK Universal Credit claims doubled from 3 million to 6 million during the pandemic, automatically putting money in people's pockets when they needed it most, without requiring new legislation.

The Bottom Line: Is Fiscal Policy Worth the Hype?

Fiscal policy is like that Swiss Army knife that's really useful but has a few blades that are a bit bent. It's powerful but imperfect.

For IB exam success, remember to evaluate fiscal policy by considering:

• Which macroeconomic objective is being targeted (growth, employment, inflation)

• The current state of the economy (recession, boom, or somewhere in between)

• The existing level of government debt

• The potential time lags involved

• The political context (is an election coming up?)

• Whether monetary policy might be more appropriate

Real-world final example: The UK's fiscal response to challenges has varied enormously - from Keynesian stimulus during the 2008 crisis and COVID-19 pandemic to monetarist-inspired austerity in between. Neither approach has been perfect, showing that economic policy is always a balancing act.

Remember - in economics, as in life, there are no perfect solutions, just trade-offs. And understanding those trade-offs is what makes you an economist rather than just someone who can draw a supply and demand curve!

Stay well