Fiscal Policy and Public Finance
Core concepts
Fiscal policy uses government spending and taxation to influence aggregate demand. Expansionary fiscal policy (spending up or taxes down) shifts AD right; contractionary does the opposite. Automatic stabilizers (unemployment insurance, progressive taxes) dampen cycles without new legislation.
Multiplier effect: a change in spending produces a larger change in equilibrium output; the simple spending multiplier = 1 ÷ (1 − MPC), where MPC is the marginal propensity to consume. The tax multiplier is smaller in magnitude (−MPC ÷ (1 − MPC)).
Budget balance = revenues − outlays. Deficits add to public debt. Types of deficits: cyclical (from recession) vs. structural (persistent). Crowding out occurs when government borrowing raises interest rates and reduces private investment.
Taxation principles: ability-to-pay vs. benefits received; progressive, proportional, and regressive taxes. Public finance also covers public goods provision and cost-benefit analysis.
Common traps
- Applying the full multiplier when the economy is near full employment (crowding out reduces the effect).
- Confusing deficit (annual flow) with debt (accumulated stock).
- Assuming all government spending has the same multiplier; transfers and taxes work indirectly.
- Mixing progressive (higher rate on higher income) with regressive (higher burden on lower income).
Worked example
MPC = 0.8, so the spending multiplier = 1 ÷ 0.2 = 5. A $50 billion increase in government spending raises equilibrium output by up to $250 billion. A tax cut of $50 billion raises output by only 0.8 × 5 × $50 = $200 billion.
Rule of thumb
Spending multiplier = 1 ÷ (1 − MPC). Deficits are annual; debt is cumulative. Near full employment, expect crowding out.