Expansionary & Contractionary Fiscal Policy (Cambridge (CIE) A Level Economics): Revision Note
Exam code: 9708
Expansionary fiscal policy
Expansionary fiscal policies include reducing taxes or increasing government spending with the aim of increasing AD
AD = household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
AD = C + I + G + (X - M)
Expansionary fiscal policy aims to shift aggregate demand (AD) to the right
Diagram analysis
The economy is initially in macroeconomic equilibrium AP1Y1: there is a recessionary gap
The Government wants to boost economic growth and lowers the rate of income and corporation taxes
Lower taxes cause investment and consumption to increase, which are components of AD
Aggregate demand increases from AD→ AD1
The economy reaches a new equilibrium at AP2Y2 - a higher average price level and a greater level of national output
As real output rises from Y1 to Y2, firms require more workers to produce the higher level of output - employment rises and unemployment falls
Examples of the impact of expansionary fiscal policy
Example 1: The Government decreases corporation tax | |
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Example 2: The Government increases unemployment benefits | |
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Contractionary fiscal policy
Contractionary fiscal policies include increasing taxes or decreasing government spending with the aim of decreasing AD
AD= household consumption (C) + firms investment (I) + government spending (G) + exports (X) - imports (M)
AD = C + I + G + (X - M)
Changes to fiscal policy can influence government spending or consumption or investment
Changing taxation can influence household consumption and the investment by firms
Contractionary fiscal policies aims to shift aggregate demand (AD) to the left
Diagram analysis
The economy is initially in macroeconomic equilibrium AP1YFE - an inflationary output gap is developing
The economy is booming and the Government wants to lower inflation towards its target of 2%
The Government increases the rate of income tax
Higher tax rates cause households to have less discretionary income, causing consumption to decrease
Aggregate demand decreases from AD1→ AD2
The economy reaches a new equilibrium at AP2Y1 - a lower average price level and a smaller level of national output
As real output falls from YFE to Y1, firms require fewer workers - employment falls and unemployment rises
Examples of the impact of contractionary fiscal policy
Example 1: The Government increases the rate of income tax | |
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Impact on macroeconomic aims |
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Example 2: The Government freezes/reduces public sector workers pay | |
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Example 3: The Government cuts Government Spending in their Budget | |
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Worked Example
The government of a country plans to raise income tax rates. The initial equilibrium for the country is represented by point X on the diagram.
Which new equilibrium point would an economist predict as the result?
A B C D
Answer: B
Worked solution
Step 1 - identify which curve shifts and in which direction:
Raising income tax is contractionary fiscal policy - it reduces household disposable income, which reduces consumption (C), which is a component of AD
AD shifts left - from AD1 towards AD2
The AS curve does not shift - income tax does not directly affect costs of production
Step 2 - identify the new equilibrium:
The new equilibrium must be to the left of X - lower real national income
The price level must be lower - AD has fallen along the same AS curve
Point B sits correctly to the left of X at a lower price level on the same AS curve
Eliminating the wrong answers:
A - too far left and too low; would require a much larger tax increase than implied
C - sits on a different AS curve (AS2); income tax does not shift AS
D - below the AS curve entirely; cannot be an equilibrium position
The effect on all three variables:
Real output falls - lower national income
Price level falls - inflationary pressure eases
Employment falls - firms reduce output and demand less labour, unemployment rises
The trap is option C - students who confuse the effect of income tax on AS (via labour supply) rather than AD may incorrectly select this. At AS Level the primary effect of income tax is on household disposable income and therefore AD, not on productive capacity
Examiner Tips and Tricks
Always identify which curve shifts and why before locating the new equilibrium. Fiscal policy operates primarily through AD - tax cuts and spending increases shift AD right; tax rises and spending cuts shift AD left. The AS curve only shifts if the policy directly affects costs of production or productive capacity.
For the impact on all three variables, use the following framework every time: a rightward AD shift raises real output, raises the price level, and raises employment; a leftward AD shift does the opposite.
The position on the AS curve matters - if the economy is on the elastic section of the Keynesian LRAS, an AD shift has a larger output effect and smaller price effect than if the economy is near full capacity.
Fiscal policy and aggregate supply
Many fiscal policies have the ability to improve the productive potential (supply-side) of an economy
E.g. Education subsidies to help the poorest households constitute an annual expenditure for the government
However, in the long term, they help to improve human capital, which boosts productivity and output
The fiscal policy is short-term (annually); however, the supply-side impact occurs in the long term
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