Fiscal policy is the government using its own chequebook to steer the economy. It spends and it taxes, and the difference between those two numbers is the budget. Everything in this page comes back to one equation you already know: AD = C + I + G + (X − M).
📚 What you need to know
Fiscal policy uses government spending and taxation to influence aggregate demand.
Expansionary: spend more or tax less → AD shifts right. Contractionary: spend less or tax more → AD shifts left.
The government budget is presented roughly once a year. Revenue = expenditure is balanced; revenue < expenditure is a deficit; revenue > expenditure is a surplus.
A deficit is funded by public sector borrowing, which adds to the public debt.
Spending comes in three kinds: current, capital and transfer payments.
Transfer payments are not part of AD — nothing is produced, income is only moved.
Where the money comes from and where it goes
Government revenue has three sources: taxation (much the biggest), charges for goods and services provided by state-owned firms, and sales of state assets through privatisation. That last one is a one-off — you can only sell the national railway once.
Spending divides into three types, and the difference matters for AD.
Type
What it is
In AD?
Current expenditure
The day-to-day running costs: wages of teachers, nurses, police, soldiers, plus medicines and supplies.
Yes, this is G
Capital expenditure
Investment in infrastructure and equipment: railways, hospitals, schools, ports.
Yes, this is G
Transfer payments
Money handed over with nothing produced in return: unemployment and disability payments, pensions, subsidies.
No — only when the household spends it, and then it shows up as C
Deficits are not automatically bad. Borrowing to build a port that raises future output is very different from borrowing to pay this year’s wage bill.
The goals of fiscal policy
Keep inflation low and stable.
Keep unemployment low.
Smooth out the swings of the business cycle.
Create stable conditions for long-term growth.
Redistribute income so the outcome is more equitable.
Manage the balance of exports and imports.
Notice that fiscal policy has a goal monetary policy does not: redistribution. Only the government can decide who pays the tax and who receives the spending. That is a ready-made comparison point for any essay asking which policy is better.
Expansionary and contractionary fiscal policy
Both work through the same equation. Government spending G is a direct component of AD, so changing it moves AD immediately. Taxes work indirectly: cut income tax and households have more disposable income, so C rises; cut corporation tax and firms keep more profit, so I rises.
Aggregate demand
AD = C + I + G + (X − M)
On a Keynesian AS curve the same rightward shift raises output with almost no price rise when the economy is well below full employment — which is exactly the case for using fiscal policy in a slump.
Worked chains you can reuse
Policy
Chain of reasoning
Effect on the objectives
Cut corporation tax
Firms keep more profit → investment rises → AD rises
Growth up, inflation up, unemployment down; net exports unclear
Raise unemployment benefits
Household income rises → consumption rises → AD rises
Growth up, inflation up, income distribution more equal
Raise income tax
Disposable income falls → consumption falls → AD falls
Growth slows, inflation eases, unemployment may rise
Cut government spending
Less demand for goods and services → firms’ output and profit fall → AD falls
Growth slows, inflation eases, imports may fall so the trade balance improves
Watch for the conflict. Expansionary fiscal policy lifts growth and cuts unemployment, but it also pushes prices up and sucks in imports. There is almost never a policy that improves all four objectives at once, and saying so is a fast route to evaluation marks.
💡 Exam tips
Always state which component of AD your policy moves before you say AD shifts.
Choose your AS curve deliberately. Keynesian for a recession, classical for near full employment, and say why you chose it.
Use the words deficit, surplus and balanced precisely. They compare revenue with expenditure, not spending with last year.
Remember that fiscal policy can be targeted at a region or industry. Monetary policy cannot.
Note that a deficit adds to debt, and interest on that debt is a real future cost.
Label both equilibrium points on the diagram and show the new price level and output.
⚠ Common mix-ups
Counting transfer payments in G. No output is produced, so they are not part of AD directly.
Deficit versus debt. The deficit is this year’s shortfall; the debt is the total of all past shortfalls.
Thinking a surplus is always good. A surplus in a recession means the government is draining demand when the economy needs it.
Confusing the direction of a tax change. Higher tax means lower AD.
Forgetting the price level. Expansionary fiscal policy raises output and prices together.
Shifting AS. Fiscal policy is demand-side here — its supply-side effects come later and belong to 3.7.
Up next: The Keynesian Multiplier — the HL idea that explains why $1 of government spending ends up raising national income by more than $1.
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