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3.6

Demand management: fiscal policy

Unit 3 · Macroeconomics · SL and HL

Fiscal policy is the government’s use of taxation and spending to influence the economy. It is decided by the government and parliament, not the central bank, and in Indonesia it is set out each year in the state budget (APBN). This page covers where revenue comes from, what it is spent on, how expansionary and contractionary fiscal policy move AD in each school of thought, and why it is powerful in deep recessions but slow and politically awkward. At HL, the Keynesian multiplier and crowding out are calculated and drawn.

🎯What you need to be able to do

  • Explain sources of government revenue (direct and indirect taxes, sales of goods and services by state-owned enterprises, sales of government assets) and types of expenditure (current, capital, transfer payments).
  • Explain the goals of fiscal policy: low and stable inflation, low unemployment, a stable environment for long-term growth, reducing business-cycle fluctuations, equitable income distribution, external balance.
  • Draw AD/AS diagrams showing expansionary and contractionary fiscal policy in both the Keynesian and monetarist/new classical models.
  • Evaluate fiscal policy: constraints (political pressure, time lags, sustainable debt) and strengths (targeting sectors, effectiveness in deep recession).
  • HL Calculate the Keynesian multiplier and its effect on GDP; explain crowding out with a diagram; explain automatic stabilizers.

📚The economics

Government revenue and expenditure

Sources of revenue
Direct taxes on income, profits and wealth; indirect taxes on spending (VAT, excise on tobacco and fuel); sales of goods and services by state-owned enterprises (profits and dividends from Pertamina, PLN, state banks); sale of government assets (privatization). Also non-tax revenue such as natural resource royalties.
Expenditure
Current expenditure: day-to-day spending on wages of teachers, nurses and civil servants, medicines, maintenance. Capital expenditure: investment in roads, ports, schools, hospitals, dams. Transfer payments: pensions, unemployment benefits, cash transfers; they redistribute income and are not payment for output.

If spending exceeds revenue in a year, the government runs a budget deficit, financed by borrowing; if revenue exceeds spending, a surplus. Accumulated deficits form government debt (3.3).

Goals of fiscal policy

Fiscal policy shares the macro goals of monetary policy (low and stable inflation, low unemployment, a stable environment for growth, smoothing the business cycle, external balance) and adds one monetary policy cannot easily reach: an equitable distribution of income, through progressive taxes, transfers and public services (3.4).

Expansionary and contractionary fiscal policy

Left: expansionary fiscal policy shifts AD1 right to AD2, closing a deflationary gap and raising output from Y1 to full employment Yf. Right: contractionary fiscal policy shifts AD1 left to AD2, closing an inflationary gap and bringing output down to Yf.
Fiscal policy shifts AD through G directly and through taxes on C and I.
Expansionary fiscal policy
increase government spending and/or cut taxes. G rises directly; lower income taxes raise disposable income and C; lower business taxes raise I. AD shifts right, closing a deflationary gap, but the budget deficit grows. During the pandemic, Indonesia’s PEN recovery programme and cash transfers are an example.
Contractionary fiscal policy
cut government spending and/or raise taxes. AD shifts left, closing an inflationary gap and reducing the deficit (“fiscal consolidation” or austerity). Politically unpopular.

The two schools disagree about how much fiscal policy can achieve:

Left, Keynesian: with spare capacity on the horizontal section of AS, a rise in AD from AD1 to AD2 raises real GDP from Y1 to Y2 with no change in the price level. Right, monetarist: at full employment on a vertical LRAS, a rise in AD raises only the price level from PL1 to PL2.
Keynesians see fiscal policy raising output; monetarists see it raising only prices in the long run.
  • Keynesian: in a recession there is plenty of spare capacity, so higher G raises real output and employment with little inflation, and the multiplier magnifies the effect. Governments should actively use fiscal policy.
  • Monetarist/new classical: the economy returns to full employment anyway; in the long run higher AD just raises the price level (vertical LRAS). Deficits also crowd out private investment. Fiscal policy should aim for balanced budgets and sound finances.

The Keynesian multiplier HL

An injection of spending (G, I or X) raises national income by more than the initial amount, because one person’s spending is another’s income. When the government pays construction firms, workers receive wages and spend part of them, those shopkeepers spend part of that, and so on. At each round some income leaks out as saving, taxes and imports.

\[ k = \frac{1}{1 - \text{MPC}} = \frac{1}{\text{MPS} + \text{MPT} + \text{MPM}} \qquad \Delta \text{GDP} = k \times \Delta \text{injection} \]
  • MPC (marginal propensity to consume) is the fraction of extra income spent on domestic output; MPS, MPT and MPM are the fractions of extra income saved, taxed and spent on imports. MPC + MPS + MPT + MPM = 1.
  • The larger the leakages, the smaller the multiplier. Open economies that import a lot, and economies with high taxes, have smaller multipliers.
  • The multiplier also works in reverse: a fall in investment or exports reduces GDP by a multiple.
A bar chart of extra income in successive rounds after 40 billion dollars of extra government spending: 40, 24, 14.4, 8.6, 5.2, 3.1, 1.9. Each round, 60 per cent is spent on domestic output. The multiplier is 1 divided by 0.4, which is 2.5, so GDP rises by 100 billion dollars in total.
The rounds shrink by the fraction that leaks out, and add up to k × the injection.

Crowding out HL

If the government borrows to fund a deficit, it competes with private firms and households for the available supply of loanable funds (savings). Demand for loanable funds rises, real interest rates rise, and some private investment and consumption that would have happened is crowded out. So the net rise in AD is smaller than the rise in G. Monetarists see crowding out as strong; Keynesians argue it is weak in a recession, when saving is plentiful and private investment is low anyway.

A loanable funds market. Government borrowing shifts demand for loanable funds from DLF1 to DLF2, raising the real interest rate from r1 to r2. At the higher rate, private borrowing along the original demand curve falls.
Higher government borrowing pushes up interest rates, reducing private borrowing.

Automatic stabilizers HL

Some fiscal effects happen automatically, without any new decision:

  • Progressive income taxes: in a boom, incomes rise and people move into higher tax bands, so tax revenue rises faster than income, slowing spending growth. In a recession, tax payments fall faster than income, cushioning disposable income.
  • Unemployment benefits: spending rises automatically as unemployment rises in a recession, supporting consumption, and falls in a boom.

They reduce the size of fluctuations with no time lag for decision-making. They are weaker in countries with small formal tax bases and limited benefit systems.

How effective is fiscal policy?

Constraints:

  • Political pressure: governments find it easy to spend and cut taxes before elections, hard to do the reverse in a boom, so fiscal policy is often too loose (a deficit bias).
  • Time lags: recognizing the problem, passing a budget, and implementing projects (infrastructure takes years) mean stimulus may arrive after the recession is over.
  • Sustainable debt: countries with high debt, or which borrow in foreign currencies, face rising interest costs and credit-rating downgrades; Indonesia’s legal 3%-of-GDP deficit ceiling limits room for stimulus.
  • HL Crowding out reduces the net effect on AD.
  • Tax cuts may be saved rather than spent if confidence is low; leakages reduce the multiplier.

Strengths:

  • Can target specific sectors and regions (tourism in Bali after the pandemic, infrastructure in eastern Indonesia) and specific groups (cash transfers to the poor), and can promote equity.
  • Effective in a deep recession, when monetary policy is stuck at low interest rates and confidence is low: government spending directly creates demand whatever households and firms do.
  • Capital spending on infrastructure and education also raises long-run productive capacity (a supply-side effect, 3.7).
  • HL Automatic stabilizers work without lags.

✏️Worked example HL

In an economy, out of each extra $1 of income, households save $0.10, pay $0.15 in tax and spend $0.15 on imports.
(a) Calculate the MPC (on domestic output) and the multiplier.
(b) The government raises spending on infrastructure by $40 bn. Calculate the eventual change in GDP.
(c) Real GDP is $2000 bn and potential output $2080 bn. Calculate the change in government spending needed to close the deflationary gap.

(a) Leakages = 0.10 + 0.15 + 0.15 = 0.40, so MPC = 1 − 0.40 = 0.60.

\[ k = \frac{1}{0.40} = 2.5 \]

(b) ΔGDP = 2.5 × 40 = $100 bn (40 + 24 + 14.4 + 8.64 + …).

(c) The gap is 2080 − 2000 = $80 bn. Required ΔG = 80 ÷ 2.5 = $32 bn.

Check it. The first round is the injection itself (40), and each later round is 0.6 of the one before: 40 × 0.6 = 24, 24 × 0.6 = 14.4. The multiplier must be greater than 1 whenever the MPC is positive.
Using MPS alone. 1 ÷ MPS = 1 ÷ 0.1 = 10 ignores taxes and imports, overstating the effect four times. Use all three leakages unless the question says it is a closed economy with no government.

📝Practise

Tagged questions are modelled on a real IB question from that session, with our own wording, numbers and context.

1. [2 marks, Paper 2 style] Define the term transfer payments.
Payments by the government to individuals for which no good or service is provided in return, such as pensions, unemployment benefits and cash transfers; they redistribute income.
2. [10 marks, Paper 1 (a) — modelled on November 2022 SL Paper 1 Q2(a)] Explain how fiscal policy can be used to narrow income inequality and to smooth the business cycle.
Choose two, e.g. low unemployment (expansionary policy in a recession shifts AD right, closing a deflationary gap; diagram) and equitable distribution of income (progressive taxes and transfer payments redistribute; Lorenz curve shifts towards the diagonal). Or low and stable inflation (contractionary policy to close an inflationary gap). Define fiscal policy, explain each mechanism fully, link to a diagram.
3. HL [Paper 3 style] MPS = 0.2, MPT = 0.2, MPM = 0.1. Exports fall by $15 bn. Calculate the multiplier and the change in GDP.
k = 1 ÷ (0.2 + 0.2 + 0.1) = 1 ÷ 0.5 = 2. ΔGDP = 2 × (−15) = −$30 bn.
4. [10 marks, Paper 1 (a) — modelled on May 2024 HL Paper 1 Q2(a)] With reference to the multiplier, explain how a road-building programme could raise real GDP by more than its cost.
G is an injection and a component of AD: AD shifts right. The spending becomes income for workers and firms, who spend a fraction (MPC) on domestic goods, creating further rounds of income; leakages (S, T, M) make each round smaller. The total rise in GDP = k × ΔG, with k = 1 ÷ (1 − MPC). Numerical illustration and an AD/AS diagram showing AD shifting right by more than the initial ΔG, raising real GDP in the short run (actual growth), especially with a deflationary gap. Note that the effect is smaller with high leakages or crowding out.
5. [15 marks, Paper 1 (b) — modelled on November 2022 SL Paper 1 Q2(b)] Using real-world examples, discuss the case for a large government stimulus package during a recession.

Case for: directly raises AD (diagram), multiplier (HL), effective when monetary policy is limited at low rates and confidence is weak; can target sectors; capital spending adds supply-side benefits. Examples: 2009 stimulus packages; pandemic support programmes in 2020–21.

Limitations: time lags; political pressure; debt sustainability and deficit rules; crowding out; tax cuts saved; leakages via imports; monetarists argue only prices rise in the long run.

Judgment: most effective in deep recessions, with fiscal space, well-targeted and temporary; less so in highly indebted or very open economies.

6. [15 marks, Paper 1 (b) — modelled on May 2024 SL Paper 1 Q2(b)] Using real-world examples, compare fiscal policy and supply-side policy as ways of cutting a country’s unemployment.

Distinguish types of unemployment. Fiscal policy is effective against cyclical unemployment (AD shifts right, diagram), and targeted spending (training, public works) can help structural unemployment.

Alternatives: monetary policy (quicker to change, but weak at the zero bound); supply-side policies for structural and frictional unemployment (education, retraining, labour-market flexibility, better job matching).

Evaluation: fiscal constraints (lags, debt, crowding out); risk of inflation near full capacity; depends on the type of unemployment. Judgment: fiscal policy is most effective for cyclical unemployment in a recession, but structural unemployment needs supply-side measures.

🔗Go deeper — other people’s work

These are external resources, not mine. If one stops working, tell me and everything above it on this page still stands.

  • Kementerian Keuangan (Ministry of Finance) — APBN Kita, the monthly report on Indonesia’s state budget.
  • IMF Fiscal Monitor — deficits, debt and fiscal policy across countries.
  • Khan Academy — Fiscal policy and The multiplier.