Fiscal Policy

The Government's Two Levers

Fiscal policy is the use of government spending and taxation to steer aggregate demand directly.

• Expansionary: raise spending or cut taxes to fight recessions.
• Restrictive: cut spending or raise taxes to cool overheating.

The budget position keeps score:

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

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

Automatic stabilizers work without any vote: tax receipts fall and benefits rise automatically in a downturn, cushioning demand instantly.

Multipliers and Limits

The multiplier. One euro of spending becomes income, spent again. With a marginal propensity to consume ($MPC$), the total demand effect is:

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

Common pitfall: Textbook multipliers are unrealistically large. Real-world leakages like imports, taxes, and saving shrink the actual impact.

Limits: Slow decision lags and crowding out, where public borrowing pushes up interest rates and displaces private investment.