Fiscal Policy

The Government's Two Levers

Fiscal policy is the use of government spending and taxation to steer aggregate demand. Where monetary policy works through the price of credit, fiscal policy injects or withdraws demand directly.

Expansionary (recession): raise spending or cut taxes. Restrictive (overheating): the reverse. The budget position keeps score:

$$\text{deficit} = \text{spending} - \text{revenue}$$

Deficits accumulate into public debt — future taxpayers financing today's demand.

The multiplier. One euro of government spending becomes someone's income, part of which is spent again, becoming another income… With a marginal propensity to consume $MPC$, the total demand effect of an extra euro is

$$\text{multiplier} = \frac{1}{1 - MPC}$$

An $MPC$ of 0.75 gives a multiplier of 4 in the textbook case — real-world leakages (imports, taxes, saving) shrink it considerably.

Automatic stabilizers work without any vote: in a downturn, tax receipts fall and unemployment benefits rise by themselves, cushioning demand; in a boom they quietly brake. They are fiscal policy's reflexes, faster than any parliament.

The limits: decision and implementation lags (budgets take months); debt sustainability; and crowding out — heavy public borrowing can push up interest rates and displace the private investment it hoped to encourage. Fiscal power is real, but it is a blunt instrument with a long invoice.

Fiscal vs monetary at a glance

Common pitfall: Quoting the textbook multiplier $1/(1-MPC)$ as the real-world effect. Imports, taxes, and saving all leak demand out of the spending loop — measured multipliers are far smaller than the formula's 4.