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Macroeconomics Foundations (ECON 102) · Module 3 of 7

Fiscal Policy

Government spending and taxes as stabilization tools, the multipliers, automatic stabilizers, deficits, and crowding out.

In this module
  1. Expansionary & Contractionary Fiscal Policy
  2. The Spending & Tax Multipliers
  3. Deficits, Debt & Crowding Out
  4. Check yourself

Expansionary & Contractionary Fiscal Policy

  • Expansionary fiscal policy (more government spending, lower taxes) shifts AD right to close a recessionary gap. Contractionary policy (less spending, higher taxes) shifts AD left to close an inflationary gap.
  • Automatic stabilizers, such as progressive income taxes and unemployment benefits, soften the business cycle without new legislation.
  • Discretionary fiscal policy faces time lags: recognizing the problem, passing a law, and the effects taking hold.
Worked example

During a recession, tax revenue falls and unemployment payments rise, with no new laws passed. What is this called?

Solution. Automatic stabilizers. They increase disposable income in a downturn and cushion the fall in AD.

The Spending & Tax Multipliers

  • MPC + MPS = 1. The spending multiplier = 1 / MPS = 1 / (1 − MPC).
  • The tax multiplier = −MPC / MPS. It is smaller in size than the spending multiplier, because part of a tax cut is saved before it is spent.
  • A change in spending and taxes by the same amount (a balanced-budget change) has a multiplier of 1.
Worked example

MPC = 0.8. Government spending rises by $100B. What is the maximum change in real GDP? What if taxes are cut by $100B instead?

Solution. Spending multiplier = 1/0.2 = 5 → GDP rises by up to $500B. Tax multiplier = −0.8/0.2 = −4, so a $100B tax cut raises GDP by up to $400B.

Deficits, Debt & Crowding Out

  • A budget deficit is one year's shortfall (spending > revenue). The national debt is the total accumulated from past deficits.
  • Crowding out: government borrowing increases the demand for loanable funds, which raises the real interest rate and reduces private investment. That can slow long-run growth.
Worked example

Use the loanable funds market to show how a larger deficit affects private investment.

Solution. The government borrows more, so the demand for loanable funds shifts right (or supply shifts left). The real interest rate rises, and interest-sensitive private investment falls.

Check yourself

2 of this module's 5 quiz questions. Pick your answers, then check them in the app, with an explanation for every question.

1. If the MPC is 0.75, the spending multiplier is:

2. With MPC = 0.9, a $10B tax cut can increase real GDP by up to:

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