What is the difference between fiscal and monetary policy?

Fiscal policy is the government changing spending and taxation to shift aggregate demand. Monetary policy is the central bank changing interest rates and the money supply. Fiscal policy can target specific groups and works at the zero lower bound, but faces political lags and debt; monetary policy adjusts faster but can stall in a liquidity trap.

How do you calculate the spending multiplier?

Use k = 1 / (1 - MPC), which also equals 1 / MPS. If the MPC is 0.8, then k = 1 / (1 - 0.8) = 5, so a 10 billion rise in spending raises real GDP by 50 billion. In an open economy with taxes and imports, use k = 1 / (MPS + MPT + MPM), which gives a smaller figure.

What is crowding out?

Crowding out is when heavy government borrowing to fund a deficit raises interest rates and competes for loanable funds, reducing private investment and consumption. It offsets part of the intended fiscal boost. The effect is weaker in a deep recession with spare savings and low interest rates.

What are automatic stabilisers?

Automatic stabilisers are features of the budget that dampen the business cycle without any new decision. In a downturn, progressive taxes fall and unemployment benefits rise, supporting demand; in a boom the reverse cools the economy. They act faster than discretionary policy because no new law is needed.

IB Economics · Unit 3: Macroeconomics · 3.6

Fiscal Policy: IB Economics 3.6 notes

Government use of spending and taxation to influence aggregate demand, close output gaps, and pursue growth, low inflation, and full employment.

Best studied with a graph you can move: AD-AS: fiscal policy shifting AD

The government budget

Fiscal policy uses government spending and taxation to influence aggregate demand. The budget has two sides. Revenue comes mainly from direct taxes (on income and company profits), indirect taxes (VAT or GST and excise duties on fuel, alcohol, and tobacco), plus fees and returns from state assets like Norway's oil holdings. Expenditure splits into current spending (public-sector wages and transfer payments such as pensions and unemployment benefits), capital spending (investment in roads, schools, and hospitals), and interest on government debt.

When spending exceeds revenue the government runs a budget deficit and must borrow; when revenue exceeds spending it runs a surplus. The accumulated stock of past deficits is the national debt.

Expansionary and contractionary fiscal policy

Expansionary fiscal policy raises government spending and/or cuts taxes to increase aggregate demand when output is below full employment. Contractionary fiscal policy cuts spending and/or raises taxes to reduce aggregate demand and control demand-pull inflation, which usually also improves the budget balance.

Because G is a direct component of AD, government spending changes hit demand immediately, while tax changes work indirectly by altering households' disposable income and firms' retained profit.

Automatic stabilisers

Some fiscal effects happen without any new decision. In a downturn, progressive income taxes take a smaller share as incomes fall while unemployment benefit payments rise automatically, which props up disposable income and demand. In a boom the same mechanisms work in reverse, cooling the economy. These automatic stabilisers dampen the business cycle without the time lags of new legislation.

The Keynesian multiplier (HL)

An initial injection of spending circulates through the economy and generates a larger final rise in national income. The size depends on how much of each extra unit of income households pass on. The spending multiplier is k = 1 / (1 - MPC), where MPC is the marginal propensity to consume, and equivalently k = 1 / MPS.

Worked example: suppose the MPC is 0.8, so households spend 80% of each extra unit of income and save 20% (MPS = 0.2). The multiplier is 1 / (1 - 0.8) = 1 / 0.2 = 5. A government increase in spending of 10 billion therefore raises real GDP by 10 billion multiplied by 5, which is 50 billion. In an open economy with taxes and imports, the denominator also includes the marginal propensity to tax and to import, so k = 1 / (MPS + MPT + MPM), giving a smaller multiplier. Practise this at /calculate/spending-multiplier.

Crowding out

When a government borrows heavily to fund a deficit it competes with private borrowers for loanable funds, pushing up interest rates and reducing private investment and consumption. This crowding out can offset part of the intended boost to aggregate demand. The effect is weaker in a deep recession with idle savings and near-zero interest rates, which is exactly when Keynesians argue fiscal expansion works best.

Strengths and limitations vs monetary policy

Strengths: fiscal policy can target specific regions, sectors, or income groups; government spending affects AD directly once enacted; and it still works at the zero lower bound where monetary policy stalls. Capital spending on infrastructure and education can also raise the economy's productive capacity, blurring into supply-side policy.

Limitations: it faces long political and implementation lags, because budgets must pass parliaments and projects take time to build; persistent deficits raise the national debt and interest burden; crowding out can dilute it; and spending decisions can be distorted by the political cycle. Monetary policy, by contrast, is quicker to adjust and free of political bargaining.

Real-world example

During the COVID-19 shock of 2020, governments ran large expansionary fiscal policy. The United States passed multi-trillion-dollar packages of transfers and business support, while the European Union created the 750-billion-euro NextGenerationEU recovery fund, and Germany temporarily suspended its constitutional debt brake to allow the borrowing. These programmes lifted aggregate demand sharply but contributed to rising public debt and, alongside supply shocks, to the inflation of 2021 to 2022.

Common Paper mistakes

Do not treat every tax cut as equally powerful. A cut aimed at low-income households, who have a high MPC, boosts AD more than a cut for high earners who save much of the gain.

When you use the multiplier, state the formula and show the arithmetic; Paper 3 mark schemes award method marks even if the final figure is wrong. Remember the multiplier works in both directions, so spending cuts shrink income by a multiple too.

HL extension

The Keynesian multiplier is HL-only material and appears on Paper 3 as a calculation. Learn the marginal propensities: in a closed economy with no government, MPC + MPS = 1, so the multiplier is simply 1 / (1 - MPC) = 1 / MPS. Once you add taxes and imports, the leakages are saving, tax, and imports, and the full multiplier is 1 / (MPS + MPT + MPM), where the extra leakages make it smaller.

Paper 3 may give you an MPC and an injection and ask for the change in real GDP, or work backwards from a known change to find the MPC. Always show the substitution into the formula, since method marks are available even when the final number is off.

How this is examined

Fiscal policy is common on Paper 1 essays, and the multiplier calculation is HL Paper 3 material: memorise k = 1 / (1 - MPC) and show the substitution for method marks.
In evaluation, the sharpest comparison is fiscal vs monetary policy: name crowding out, time lags, and debt as fiscal weaknesses, and the zero lower bound as a monetary weakness.
Draw fiscal policy on an AD-AS diagram by shifting AD, not AS, unless the question is about capital spending as a supply-side measure; then label the new equilibrium output and price level.
Distinguish automatic stabilisers (no new law needed) from discretionary policy (a deliberate budget decision); examiners reward the correct term.

Key terms

fiscal policy spending multiplier crowding out automatic stabilizers budget deficit expansionary fiscal policy

Frequently asked

What is the difference between fiscal and monetary policy?: Fiscal policy is the government changing spending and taxation to shift aggregate demand. Monetary policy is the central bank changing interest rates and the money supply. Fiscal policy can target specific groups and works at the zero lower bound, but faces political lags and debt; monetary policy adjusts faster but can stall in a liquidity trap.
How do you calculate the spending multiplier?: Use k = 1 / (1 - MPC), which also equals 1 / MPS. If the MPC is 0.8, then k = 1 / (1 - 0.8) = 5, so a 10 billion rise in spending raises real GDP by 50 billion. In an open economy with taxes and imports, use k = 1 / (MPS + MPT + MPM), which gives a smaller figure.
What is crowding out?: Crowding out is when heavy government borrowing to fund a deficit raises interest rates and competes for loanable funds, reducing private investment and consumption. It offsets part of the intended fiscal boost. The effect is weaker in a deep recession with spare savings and low interest rates.
What are automatic stabilisers?: Automatic stabilisers are features of the budget that dampen the business cycle without any new decision. In a downturn, progressive taxes fall and unemployment benefits rise, supporting demand; in a boom the reverse cools the economy. They act faster than discretionary policy because no new law is needed.